Corporate Finance – II

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Mapping to Curriculum

 Reading 34: Measures of Leverage

 Reading 35: Working Capital Management

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 Reading 34: Measures of Leverage

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Learning Outcomes

The candidate should be able to:

a. Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk.
b. Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of
total leverage.
c. Analyse the effect of financial leverage on a company’s net income and return on equity.
d. Calculate the breakeven quantity of sales and determine the company’s net income at various sales levels.
e. Calculate and interpret the operating breakeven quantity of sales.

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Key terms used in Leverage Analysis

Cost Structure of a company is the mix of two types of cost: (in terms of variability)
 Variable Costs fluctuate in DIRECT PROPORTION with the level of production and sales.
• Example: Raw materials cost, delivery charges

 Fixed Costs are expenses which DO NOT FLUCTUATE at all regardless of level of production
• Example: Rent, wages for salaried employees, interest on debt

Fixed costs may further be divided into:

 Operating Fixed Cost: Related to operational aspects / business model of the company.
• These are the cost related to the main / incidental activity of the business

 Financial Fixed Cost: Related to capital structure of the company

• Among Debt, Equity and Preference share, only DEBT has a fixed cost – Interest that needs to be paid
irrespective of the profits.

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Key terms used in Leverage Analysis (contd.)

Different types of risk (Variability in earnings)

1. Business Risk: risk associated with operating earnings
a) Sales Risk
i. uncertainty associated with respect to the price and quantity of goods and services/ firm’s sales
ii. Even if companies have the same cost structure, differing sales risk affects the potential variability of the
company’s profitability
b) Operating Risk
i. risk associated with the operating cost structure, in particular, the use of fixed costs in operations
ii. The greater the fixed operating costs relative to variable operating costs, the greater the operating risk

2. Financial Risk
a) Risk on PAT due to debt on capital structure
b) By taking on fixed obligations, such as debt and long term leases, the company increases its financial risk

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Meaning and Need for Leverage

 A Lever is a simple machine which enhances the input efforts to produce greater output
 Leverage is the use of fixed cost to maximize the impact for a given input
1. Operating Leverage: Use of Operating Fixed Cost to maximize the impact on Operating Profit (EBIT) for a
given change in Sales
2. Financial Leverage: Use of Financial Fixed Cost to maximize the impact on PAT for a given change in
Operating Profit (EBIT)
3. Combined Leverage: Use of total Fixed Cost to maximize the impact on PAT for a given change in Sales

 Relation with other variables: High leverage >> High risk >> High Beta >> High Ke >> Greater discount
rate that should be used in its valuation.
 The amount of financial leverage is usually a deliberate choice by the management of the company
whereas amount of operating leverage is driven by prevalent business model in each industry.
 Businesses with plants, land, equipment that can be used to collateralize borrowings may be able to use
more financial leverage than business that don’t.

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Effect of Operating Leverage on Operating Profits

Facts of the case

 Company A operates only on variable Cost whereas Company B uses some Fixed Costs ($ 100)
 During 2011 (Base Case) both companies earned $ 1,000 as Operating profit which experienced 20%
increase during 2012.
 Compare the change in EBIT for both the companies given this 20% increase in Sales.
Company A Company B

No Fixed Cost With Operational Fixed Cost

Base Case 20% incr in Sales Base Case 20% incr in Sales
Sales 1,000 1,200 1,000 1,200
Variable Cost 600 (60%) 720 (60%) 500 (50%) 600 (50%)
Contribution 400 480 500 600
Fixed Cost (Oper) - - 100 100
Operating Income (EBIT) 400 480 400 500

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Impact of Leverage – Double Edged SWORD (Construct of the Income Statement is important)

Sales decrease 10% Base Case Sales increase

10%
Operational

Sales 1,000
Variable Cost 600
Contribution 400
Fixed Cost (Oper) 100 100 100
Combined

Operating Income (EBIT) 300

EBIT decrease 10% Base Case EBIT increase 10%

Operating Income (EBIT) 300

Fixed Cost (Financial) 50 50 50
PBT 250
Financial

TAX @ 40% 100

PAT 150
No. of Shares 100 100 100
EPS 1.5

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Degree of Operating Leverage - Formulae

Formula 1
% change ∈Operating Income
DOL=
% change ∈Sales
 Operating Income = (No. of Units Sold) X [(Price per Unit) – (Variable Cost per Unit)] – [Fixed Operating
Costs]

Formula 2

Q (P −V ) 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏
DOL= = =
Q ( P −V ) − 𝐹 𝑬𝑩𝑰𝑻 𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏− 𝑭

 Where, Q: Quantity or the no. of units produced

P: Price per unit
V: Variable price per unit
F: Fixed cost in production

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Example

Company A B

Units Produced 100000 100000

Price $5 $6

Variable Cost $4 $3

Fixed Costs $30000 $190000

Revenue $500000 $600000

DOL of Company A = 100000(5-4)/[100000(5-4)-30000] = 1.43

DOL of Company B = 100000(6-3)/[100000(6-3)-190000] = 2.73

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Degree of Financial Leverage - Formulae

Formula 1

% change∈Net Income
DFL=
% change∈Operating Income
Formula 2

Q ( P −V ) − F 𝐄𝐁𝐈𝐓 𝐄𝐁𝐈𝐓
DFL= = =
Q ( P −V ) − F − I 𝐄𝐁𝐓 𝐄𝐁𝐈𝐓 − 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭

 Where, Q: No. of units produced

P: Price per unit
V: Variable price per unit
F: Fixed cost in production

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Example

Company A B

Units Produced 100000 100000

Price $5 $6

Variable Cost $4 $3

Fixed Costs $30000 $190000

Revenue $500000 $600000

Interest Expense $20000 $30000

DOL of Company A = 100000(5-4)-30000/[100000(5-4)-30000-20000] = 1.40

DOL of Company B = 100000(6-3)-190000/[100000(6-3)-190000-30000] = 1.375

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Degree of Financial Leverage - Formulae

Formula 1

% change ∈Net Income

DCL=𝐷𝑂𝐿∗ 𝐷𝐹𝐿=
% change ∈Sales
Formula 2
N r of DOL
Q ( P −V ) 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
DTL= = =
Q (P − V )− F − I 𝐄𝐁𝐓 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 − 𝐅 − 𝐈

D r of DFL
 Where, Q: No. of units produced
P: Price per unit
V: Variable price per unit
F: Fixed cost in production

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Breakeven Points

 The breakeven points QBE is the number of units produced at which the company’s net income is zero or
the point at which revenues are equal to cost

 Q BE=OpFC + ∫¿ 𝐓𝐨𝐭𝐚𝐥𝐅𝐢𝐱𝐞𝐝 𝐂𝐨𝐬𝐭𝐬

= ¿
P −V 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭

 Firms with higher leverage have higher break even quantities, all else equal.
Revenue Revenue
and Total Cost
Costs ($)

Variable Cost

Total Fixed Cost

Output (No. of units)

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Operating Breakeven Points

 When the breakeven point is specified in terms of the operating profit then it is known as the operating
breakeven point

 Revenues at the operating breakeven point are set equal to operating costs at the operating breakeven point
to solve for the operating break even quantity.

F 𝐎𝐧𝐥𝐲 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐨𝐧𝐚𝐥 𝐅𝐢𝐱𝐞𝐝 𝐂𝐨𝐬𝐭𝐬

Q BE= =
P −V 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭

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Quick Summary

 Leverage is the use of fixed costs in a company’s cost structure.

 Business risk is the risk associated with operating earnings and reflects
a) sales risk (uncertainty with respect to the price and quantity of sales) and
b) operating risk (the risk related to the use of fixed costs in operations).
 Financial risk is the risk associated with how a company finances its operations (i.e., the split between equity
and debt financing of the business).
 The degree of operating leverage (DOL) is the sensitivity of operating earnings to changes in units produced
and sold.
 The degree of financial leverage (DFL) is the sensitivity of cash flows to owners to changes in operating
earnings.
 The degree of total leverage (DTL) is the sensitivity of the cash flows to owners to changes in unit sales.
 The breakeven point, QBE, is the number of units produced and sold at which the company’s net income is
zero.
 The operating breakeven point, QOBE, is the number of units produced and sold at which the company’s
operating income is zero.

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Question: Degree of Total Leverage

1. A company XYZ Ltd sells 10,000 units of water bottles at a price of $4 per unit. ABC’s fixed costs are
$10,000 and it pays an annual interest of $3,000. The variable cost of production is $2 per unit. Which of the
following statements is true?
A. Degree of Total Leverage = 2.86
B. Degree of Total Leverage = 1.91
C. Degree of Total Leverage = 3.00
2. Given that a company XYZ manufactures 10,000 widgets, where each can be sold in the market for $24. The
variable cost per widget is $12, while the fixed costs are $100,000. What is the operating leverage?
A. 7.2 B. 6.0 C.8.5
3. The operating leverage for ABC is 6 and the operating income on sale of 10,000 cars is $24,000. The
interest cost is $15,000. Calculate the degree of financial total leverage.

DFL DTL
A 3.45 10
B 1.45 14
C 2.67 16

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Questions(cont..)

4. Company iPaxx is planning to launch a new personal communicator. The device is considered to be highly
innovative and is eagerly anticipated by their customers. The total fixed cost in development has been $24
mn with per unit contribution margin expected to be around $12,000. The company had borrowed from the
market to fund its development. The interest costs are around $5 mn. The operating break-even point and
the break-even points are the closest to:

QOBE QBE
A 2,000 2,417
B 2,417 2,000
C 2,120 2,230

5. Business Risk is a combination of:

A. Sales risk and financial risk
B. Operating risk and financial risk
C. Sales risk and operating risk

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Solution: Degree of Total Leverage

1. Ans:
Hence, the Degree of Operating Leverage = 10,000*($4-$2)/ (10,000*($4-$2) -$10,000) = 2.00
Degree of Financial leverage = EBIT/ (EBIT - Interest) = $14,000/ ($14,000-$3,000) = 1.43
Degree of Total Leverage = 2.0*1.43 = 2.86

2. Ans: B
10,000 ∗(24 − 12)
DOL= =6.0
10,000 ∗ ( 24 −12 ) −100,000
3. Ans: C
24,000
DFL=
24 , 000 −15,000
=2.67 DTL=𝐷 𝑂𝐿 ∗𝐷𝐹𝐿=6 ∗2.67=16
4. Ans: A
24 𝑚𝑛
𝑄 𝑂𝐵𝐸= =2,000 𝑢𝑛𝑖𝑡𝑠
12 ,000
24 𝑚𝑛+5 𝑚𝑛
𝑄 𝑂𝐵𝐸= =2,417 𝑢𝑛𝑖𝑡𝑠
12 , 000
5. Ans: C - Business Risk is a combination of sales risk and operating risk.

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Effect of Financial Leverage on Net Income and Return on Equity

Facts of the case

 Consider a company, Great Everest Infrastructure, with net revenue as $20 Million.
 Its operating profit being $10 Million. Its tax rate is 40%.
 It has no debt and $20 Million in shares outstanding. (FV 100)
 If the company had issued $10 million at 8% per annum in debt to buyback $10 Million worth of shares from
the market, compare Net Incomes and Returns on Equity.
Scenario 1 Scenario 2
No Debt 50% Debt
Operating Profit 10,000,000 10,000,000
Interest Expense 0 800,000
EBT 10,000,000 9,200,000
Tax @ 40% 4,000,000 3,680,000
Net Income 6,000,000 5,520,000
No. of Equity Share 200,000 100,000
EPS 30 55.2
ROE 30% 55.2 %

 Net Income Decreases, ROE increases

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 Knowledge Check

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Knowledge Check

1. Consider two companies that operate in the same line of business and have the same degree of operating
leverage: the Basic Company and the Grundlegend Company. The Basic Company and the Grundlegend
Company have, respectively, no debt and 50 percent debt in their capital structure. Which of the following
statements is most accurate? Compared to the Basic Company, the Grundlegend Company has:
A. a lower sensitivity of net income to changes in unit sales.
B. the same sensitivity of operating income to changes in unit sales.
C. the same sensitivity of net income to changes in operating income.
2. Myundia Motors now sells 1 million units at ¥3,529 per unit. Fixed operating costs are ¥1,290 million and
variable operating costs are ¥1,500 per unit. If the company pays ¥410 million in interest, the levels of sales
at the operating breakeven and breakeven points are, respectively:
A. ¥1,500,000,000 and ¥2,257,612,900.
B. ¥2,243,671,760 and ¥2,956,776,737.
C. ¥2,975,148,800 and ¥3,529,000,000.

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Solution

 Solution: 1. B.
Grundlegend’s degree of operating leverage is the same as Basic Company’s, whereas Grundlegend’s
degree of total leverage and degree of financial leverage are higher.

 Solution: 2. B.

2,243,671,760
or

2,956,776,737
or

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Knowledge Check

3. Juan Alavanca is evaluating the risk of two companies in the machinery industry: The Gearing Company and
Hebelkraft, Inc. Alavanca used the latest fiscal year’s financial statements and interviews with managers of
the respective companies to gather the following information:

The Gearing Company Hebelkraft, Inc.

Number of units produced and sold 1 million 1.5 million

Sales price per unit $200 $200

Variable cost per unit $120 $100

Fixed operating cost $40 million $90 million

Fixed financing expense $20 million $20 million

Based on this information, the breakeven points for The Gearing Company and Hebelkraft, Inc. are:
A. 0.75 million and 1.1 million units, respectively.
B. 1 million and 1.5 million units, respectively.
C. 1.5 million and 0.75 million units, respectively.

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Solution

 Solution: 3. A.
For The Gearing Company,

For The Gearing Company,

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Knowledge Check

The following information relates to Questions 4–12

Mary Benn, CFA, is a financial analyst for Twin Fields Investments, located in Storrs, Connecticut, USA. She has
been asked by her supervisor, Bill Cho, to examine two small Japanese cell phone component manufacturers:
4G, Inc. and Qphone Corp. Cho indicates that his clients are most interested in the use of leverage by 4G and
Qphone. Benn states, “I will have to specifically analyze each company’s respective business risk, sales risk,
operating risk, and financial risk.” “Fine, I’ll check back with you shortly,” Cho, answers.
Benn begins her analysis by examining the sales prospects of the two firms. The results of her sales analysis
appear in Exhibit 1. She also expects very little price variability for these cell phones. She next gathers more data
on these two companies to assist her analysis of their operating and financial risk.
When Cho inquires as to her progress Benn responds, “I have calculated Qphone’s degree of operating leverage
(DOL) and degree of financial leverage (DFL) at Qphone’s 2009 level of unit sales. I have also calculated
Qphone’s breakeven level for unit sales. I will have 4G’s leverage results shortly.”
Cho responds, “Good, I will call a meeting of some potential investors for tomorrow. Please help me explain these
concepts to them, and the differences in use of leverage by these two companies. In preparation for the meeting,
I have a number of questions”:
 “You mentioned business risk; what is included in that?”
 “How would you classify the risk due to the varying mix of variable and fixed costs?”
 “Could you conduct an analysis and tell me how the two companies will fare relative to each other in terms of
net income if their unit sales increased by 10 percent above their 2009 unit sales levels?”
 “Finally, what would be an accurate verbal description of the degree of total leverage?”

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Knowledge Check

The relevant data for analysis of 4G is contained in Exhibit 2, and Benn’s analysis of the Qphone data appears in
Exhibit 3:
Exhibit 1 Benn’s Unit Sales Estimates for 4G, Inc. and Qphone Corp.
Standard Deviation of Unit 2010 Expected Unit Sales
Company 2009 Unit Sales
Sales Growth Rate (%)
4G, Inc. 1,000,000 25,000 15
Qphone Corp. 1,500,000 10,000 15

Exhibit 2 Sales, Cost, and Expense Data for 4G, Inc. Exhibit 3 Benn’s Analysis of Qphone (At
(At Unit Sales of 1,000,000) Unit Sales of 1,500,000)
Number of units produced and sold 1,000,000
Degree of operating leverage 1.40
Sales price per unit ¥108

Variable cost per unit ¥72 Degree of financial leverage 1.15

Fixed operating cost ¥22,500,000

Fixed financing expense ¥9,000,000 Breakeven quantity (units) 571,429

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Knowledge Check

4. Based on Benn’s analysis, 4G’s sales risk relative to Qphone’s is most likely to be:
4. A lower.
5. B equal.
6. C higher.
5. What is the most appropriate response to Cho’s question regarding the components of business risk?
4. A Sales risk and financial risk.
5. B Operating risk and sales risk.
6. C Financial risk and operating risk.
6. The most appropriate response to Cho’s question regarding the classification of risk arising from the mixture
of variable and fixed costs is:
4. A sales risk.
5. B financial risk.
6. C operating risk.

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Solution

 Solution: 4. C.
Sales risk is defined as uncertainty with respect to the price or quantity of goods and services sold. 4G has a
higher standard deviation of unit sales than Qphone; in addition, 4G’s standard deviation of unit sales stated
as a fraction of its level of unit sales, at 25,000/1,000,000 = 0.025, is greater than the comparable ratio for
Qphone, 10,000/1,500,000 = 0.0067.

 Solution: 5. B.
Business risk is associated with operating earnings. Operating earnings are affected by sales risk
(uncertainty with respect to price and quantity), and operating risk (the operating cost structure and the level
of fixed costs).

 Solution: 6. C.
Operating risk refers to the risk arising from the mix of fixed and variable costs.

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Knowledge Check

7. Based on the information in Exhibit 2, the degree of operating leverage (DOL) of 4G, Inc., at unit sales of
1,000,000, is closest to:
A. 1.60.
B. 2.67.
C. 3.20.
8. Based on the information in Exhibit 2, 4G, Inc.’s degree of financial leverage (DFL), at unit sales of
1,000,000, is closest to:
A. A 1.33.
B. B 2.67.
C. C 3.00.
9. Based on the information in Exhibit 1 and Exhibit 3, Qphone’s expected percentage change in operating
income for 2010 is closest to:
A. A 17.25%.
B. B 21.00%.
C. C 24.30%.

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Solution

 Solution: 7. B.

 Solution: 8. C.
Degree of financial leverage is

 Solution: 9. B.
The degree of operating leverage of Qphone is 1.4. The percentage change in operating income is equal to
the DOL times the percentage change in units sold, therefore:
Percentage change in operating income = (DOL)(Percentage change in unit sold) = (1.4)(15%) = 21%

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Knowledge Check

10. 4G’s breakeven quantity of unit sales is closest to:

A. 437,500 units.
B. 625,000 units.
C. 875,000 units.
11. In response to Cho’s question regarding an increase in unit sales above 2009 unit sales levels, it is most
likely that 4G’s net income will increase at:
A. a slower rate than Qphone’s.
B. the same rate as Qphone’s.
C. a faster rate than Qphone’s.
12. 16 The most appropriate response to Cho’s question regarding a description of the degree of total leverage
is that degree of total leverage is:
A. the percentage change in net income divided by the percentage change in units sold.
B. the percentage change in operating income divided by the percentage change in units sold.
C. the percentage change in net income divided by the percentage change in operating income.

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Solution

 Solution: 10. C.
The breakeven quantity is computed

 Solution: 11. C.
4G, Inc.’s degree of total leverage can be shown to equal 8, whereas Qphone Corp.’s degree of total
leverage is only DOL × DFL = 1.4 × 1.15 = 1.61. Therefore, a 10 percent increase in unit sales will mean an
80 percent increase in net income for 4G, but only a 16.1 percent increase in net income for Qphone Corp.
The calculation for 4G, Inc.’s DTL is

 Solution: 12. A.
Degree of total leverage is defined as the percentage change in net income divided by the percentage
change in units sold.

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 Reading 35: Working Capital Management

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Learning Outcomes

The candidate should be able to:

a. Describe primary and secondary sources of liquidity and factors that influence a company’s liquidity position.
b. Compare a company’s liquidity measures with those of peer companies.
c. Evaluate working capital effectiveness of a company based on its operating and cash conversion cycles and
compare the compare the company’s effectiveness with that of peer companies.
d. Describe how different types of cash flows affect a company’s net daily cash position.
e. Calculate and interpret comparable yields on various securities, compare portfolio returns against a standard
benchmark, and evaluate a company’s short term investment policy guidelines.
f. Evaluate a company’s management of accounts receivable, inventory, and accounts payable over time and
compared to peer companies.
g. Evaluate the choices of short term funding available to a company and recommend a financing method.

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Meaning of Working Capital

 There are two types of capital which is required by any firm:

1. Fixed or Permanent Capital
‒ Capital which is invested in long term assets of the firm
‒ E.g. buying of machinery for production will need funds to finance it
‒ Once invested, it is blocked for a longer term

2. Working Capital
‒ Capital which is required to utilize or operate the long term assets
‒ E.g. amount blocked / utilised in
 Purchase of Raw material
 Payment of wages to workers
 Production of Finished goods
 Financing of A/Rs,
‒ Once invested, it gets released after short term after which again it is required to be invested (keeps
rotating)

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Meaning of Working Capital (Contd.)

Investment in working capital means investment into the current assets of the firm like:
 Raw Material
 WIP
 Finished Products
 Account receivable
 Prepaid expenses
Current Assets
 Assets which are likely to be converted into cash within 1 year OR 1 operating cycle whichever is longer
This need for investment into current assets of the firm is contributed by:
 Externally by Current Liabilities
 Internally by WC financing
Current Liabilities
 Liabilities which are likely to be paid within 1 year OR 1 operating cycle whichever is longer

Working capital = Current Assets - Current liability

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Trade-off in working capital management

 There is a trade-off between stricter credit terms and the ability to make sales. Too strict receivables terms
would hamper sales and lenient terms would tie up too much capital

 Inventory management is also a trade-off: High inventory levels (as might be reflected by low inventory
turnover or longer days of inventory) will cause high costs of carry and low inventory levels may result in lost
sales due to stock outs

 Accounts payable management is important as this is a source of working capital for the firm
If a firm pays its payables before their due date, cash is used unnecessarily. A too long a period in accounts
payable would spoil the relationship with the suppliers and could entail high interest costs (compared to other
sources of short term financing)

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Meaning of Liquidity (availability of cash)

 Liquidity is very closely related to Working capital. In fact, it is the mirror image of Working capital

 Liquidity : the extent to which a company is able to meet its short-term obligations using assets that can be
readily converted to cash
• In other words, it is the ability of the firm to repay (or cover) its short term liabilities (current liabilities)
• This is a cash concept (not a accrual concept)
• Lack of liquidity can lead to bankruptcy

 Liquidity Management – The ability of an organization to generate cash when and where it is needed

 It is the abundance of current assets over and above the current liabilities (which is equal to WC)
• Greater the current assets to meet current liabilities, lower the risk and thus better it is for the firm

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Two Sources of Liquidity

1. Primary Sources of Liquidity

• These are 1st resorts which are available to a firm to raise short term finance
• These include selling operational assets or increasing operational liabilities
a) Bank Accounts
b) Collections from ARs
c) Liquidation of short term maturity securities
d) Trade Credit
e) Bank lines of credit
Primary Sources of Liquidity would most likely not disturb the normal operations of the company
2. Secondary Sources of Liquidity
• These are sources that are used in case of emergency
a) From long term liability : Negotiating Debt Contracts
b) Liquidating assets : short term/long term assets
c) Filing for bankruptcy protection and reorganization

Use of secondary resources may signal a company’s deteriorating financial health

and provide liquidity at a high price

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Factors that reduce liquidity position

1. Drags: When collection reduces (lags) creating pressure from the decreased availability of funds
• Uncollected receivables
• Obsolete Inventory
• Tight Credit (difficult to raise finance>> lower inflows)

2. Pulls: when payments are made faster than scheduled i.e. accelerated cash outflows
• Making payments to Accounts Payable early
• Reduced credit limits that require prepayment of existing outstanding balance

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Comparison of a firm’s liquidity with its peers

There are different ratios using which are used together

Liquidity ratios
1.

• The ratio indicates the current assets available for each rupee of current liability. If this ratio is 2: 1, it means that
the firm is having current assets of $2 for every Re.1 of current liability.
• It also means that even if current assets become half, the firm can still meet its short-term obligations.
• Traditionally, the current ratio of 2: 1 is considered to be satisfactory as it denotes the fact that the firm is
adequately liquid in order to meet its short term obligations.
• However, too high current ratio may represent excess investment in current assets which may result in idle funds
and which may further result in low profitability since idle funds earn nothing. Similarly, too low current ratio may
represent inadequate investment in current assets which may result in low liquidity and may threaten the
solvency of the enterprise.

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Comparison of a firm’s liquidity with its peers (Contd.)

• This ratio indicates the quick assets available for each rupee of current liability.
• Traditionally, quick ratio of 1: 1 is considered to be satisfactory as it denotes the fact that the liquid assets of the
company are sufficient to meet the current liabilities.
• High Quick Ratio may represent excess investment in quick assets and low quick ratio may represent
inadequate investment in quick assets.
• Therefore, it is always recommended to maintain quick ratio as near to its ideal level of 1: 1.

2.

• The objective of this ratio is to ascertain the ability of the enterprise to meet its very short term obligations
without relying upon the realization of stock and debtors.
• A very high ratio would represent high liquidity at the cost of profitability since idle cash does not generate any
return and marketable securities generate return at a rate lower than operating return near to its ideal level of 1:
1.

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Comparison of a firm’s liquidity with its peers (Contd.)

Turnover Ratios

• This ratio explains the speed with which the debtors are converted into cash.
• If this ratio is 50 times, it means that annual credit sales are 50 times of average debtors balance.
• In other words, the amount blocked as investment in debtors is $.1 despite the fact that the company is able to
achieve sales of $50 during the years.
• Hence, it can be concluded that higher debtor turnover represents lesser funds blocked in debtors and low ratio
will represent higher funds blocked in debtors as compared to sales.

• This period shows the average period for which credit sales remain outstanding.
• In other words, it represents the promptness or slowness with which money is collected from debtors.
• Any business organization would like to achieve maximum sales, lesser funds blocked in debtors and recover
the funds as early as possible. Hence, every effort should be made to maintain high debtor’s turnover as it will
automatically represent the promptness, in collection period.
• Similarly, low debtors turnover ratio will mean that funds are late collected from debtors.

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Comparison of a firm’s liquidity with its peers (Contd.)

• The ratio explains the efficiency level of converting inventory into sales.
• The ultimate objective of any business organization is to achieve higher amount of sales but still maintaining
lower amount of stock.
• If stock turnover ratio of a company is 35 times that the company is able to achieve sales of $35 during the year
at average stock level of Re.1.
• Hence, high ratio certainly indicates efficient performance in the context of attaining higher sales at low inventory
levels.

• This ratio explains the efficiency level of the company to sell the goods as early as possible after goods being
produced. If stock velocity of a company is 10 days, it means that the company is able to sell the goods within
10 days after production.
• It is to be noted that the objective of Stock Turnover Ratio and Stock Velocity are simultaneously achieved. It
means that higher Stock turnover Ratio will automatically produce lower stock velocity period and vice-versa.

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Comparison of a firm’s liquidity with its peers (Contd.)

• This ratio represents the speed with which cash is paid to the creditors. In general, a high ratio indicates shorter
payment period and low ratio indicates late payment to creditors.
• Let us assume that creditors turnover ratio of a company is 16 times. It means that if there have been total credit
purchases of $16 during the year. $1 is the average creditors balance maintained during the year.
• Let one thing be made very clear: It is wrong to assume that late payment to creditors is favorable. The
relationship with creditors must be maintained at satisfactory level and for long lasting period. Hence, proper and
timely payment to creditors is essential

• It represents the promptness or slowness with which money is paid to the creditors.
• It is to be noted that the results of creditor’s turnover and creditor’s velocity are related to each other. Low
creditors turnover will ultimately produce the situation of delayed payment to the creditors and Vice-versa.
• It is also recommended to compare creditors Velocity with Debtors Velocity in order to ensure that one should
not make payment to creditors at a pace which is faster than the pace of receiving payment from debtors.

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Operating and Cash Conversion Cycles

Collect on Acquire Acquire

Pay
Accounts Inventory Inventory
Suppliers
Receivable for Cash for Credit

Collect on Sell
Accounts Inventory
Sell Inventory for Receivable for Credit
Credit

Operating Cycle Cash Conversion Cycle

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Working Capital Cycle

 Operating Cycle: average number of days that it takes to turn raw materials into cash proceeds from sales

 Operating Cycle = Inventory holding period + receivable collection period

 Cash conversion cycle (Net operating cycle): takes into account the time taken to pay back the suppliers
for goods purchased on credit

 Cash conversion cycle (also called ‘net’ operating cycle)

Inventory holding period + receivable collection period – Creditors payment period

= Operating cycle – Creditors Payment period

Very long cash conversion cycle is undesirable

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Measure of Liquidity – Gist

LIQUIDITY RATIOS

Current ratio = Ability to satisfy current liabilities using current assets

Quick ratio = Ability to satisfy current liabilities using the most liquid
of current assets

RATIOS INDICATING MANAGEMENT OF CURRENT ASSETS

Receivables turnover = The number of times accounts receivable are created

and collected during the period

Inventory turnover = The number of times inventory is created and sold

during the period

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Operating and Cash Conversion Cycles - Gist

Number of days of inventory = = Average time it takes

to create and sell
inventory

 Number of days of receivables = = Average time it takes

to collect on accounts
receivable

 Number of days of payables = = Average time it takes

to pay its suppliers

 Operating cycle = Number of days of inventory + Number of days of receivables

 Net operating cycle or Cash conversion cycle = Number of days of inventory + Number of days of
receivables
– Number of days of payables

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Different Elements of Working Capital

A. Current Assets
1. Cash
2. Account Receivable
3. Inventory

B. Current Liabilities
1. Accounts Payable

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Sources and Applications of Cash

Inflows Outflows
Receipts from operations, broken down by operating Payables and payroll disbursements broken down by
unit departments, etc. operating unit, departments, etc.
Funds transfers from subsidiaries, joint ventures, third
Funds transfers to subsidiaries
parties
Maturing investments Investments made
Debt proceeds (short and long term) Debt repayments
Other income items (interest, etc.) Interest and dividend payments
Tax refunds Tax payments

 Some of the short term investment instruments that can be used to manage the short term liquidity of the
firm are:
• US T-bills
• Bank certificate of deposits
• Time deposits
• Money market Mutual Funds
• Commercial Paper
• Repurchase Agreements

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Company’s Daily Cash Position

 Ideally, the company’s daily cash inflows and outflows would be equal, but the timing of these cash flows
may not match
 Must ensure that the net cash position of a company is not negative at the end of the day
 It is difficult to borrow the exact amount needed, so many companies borrow a little extra to be safe and
invest the surplus funds in the overnight or short term markets

Information from bank reporting systems is gathered and analyzed

Morning
The cash manager receives information from company sources

The cash manager receives updates from the company’s bank(s) on current – day transactions

The cash management staff is arranging short-term investments and/or loans, as necessary, through
broker-dealers from their banks or investment banks.

The cash management staff makes funds transfers.

Midday

The cash movements for the day are completed or are scheduled
for completion, and the company’s cash position is finalized.
Close of the
Necessary paperwork for all transactions is completed. Business day
Also, the running cash worksheet is updated and set for the next business day.

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Investment Policy Statement for Cash Management

To effectively utilize the cash in the firm so as not to have low or excess cash lying in the business and to earn a
market return without taking much risk (neither liquidity or default), company should have a well laid out
Investment Policy Statement (IPS) stating the objective and general guidelines for strategy.
 Purpose
• Lists and explains the reasons that the portfolio exists
• Describes the general attributes of the portfolio

 Authorities
• Identify the executives who oversee the portfolio managers who make the investments
• Procedures that must be performed if the policy is not followed.

 Limitations/Restrictions
• The types of investments that should be considered for inclusion in the portfolio
• Restrictions as to the relative amount of each security that us allowed in the overall portfolio
• Procedures is the maximum level is breached.

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Investment Policy Statement for Cash Management (Cont’d)

 Quality
• Credit Standards for potential investments
• Reference can be made to long term ratings or short term ratings

 Other Items
• Such as “portfolio must be included in the audit”
• “ Regular reports will be made by the investment manager”

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Management of Accounts Receivable

Three primary activities in managing accounts receivable

1. Granting credit and processing transactions
• Create a record and posting customer payments
2. Monitoring credit balances
• Requires a regular reporting of outstanding balances and notify collection managers of past due situations
3. Measuring performance of the credit function
• Preparing and distributing key performance measurement reports including an accounts receivable using aging
schedule and days sales outstanding reports.

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Accounts Receivable Aging Schedule

No. of days outstanding May June July August

1-30 days 160 150 155 130

31-60 days 60 75 80 70

61-90 40 50 40 45

>90 30 20 20 30

Total Accounts Receivable 290 295 295 275

Aging Expressed % May June July August

1-30 days 55% 51% 53% 47%

31-60 days 21% 25% 27% 25%

61-90 days 14% 17% 14% 16%

>90 days 10% 7% 7% 11%

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Weighted Average Collection Period

 Average collection period is the time period (hypothetical) after which all the outstanding account receivables
(as on the date of the calculation) will be received
 For each aging category, the median point is considered to be the average time of receipt from that category
of account receivables
 Percentage of the account receivable from the aging schedule is treated as Weights

Month of May

Aging Group Average Collection Days Weight Weighted Days

1-30 days 15 55% 8.25

31-60 days 45 21% 9.45

61-90 days 75 14% 10.5

>90 days 135 10% 13.5

Weighted Average Collection Days 41.7

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Inventory Management

 Primary goal of inventory management is to maintain the level of inventory at a level so that
• All sales opportunities are exploited (Lost sales)
• Surplus funds are not blocked

 Motives for holding Inventory

1. Transaction Motive: reflects the need for inventory as part of routine production-sales cycle.
2. Precautionary Motive: reflects the need to keep stock to avoid any stock-out losses
3. Speculative Motive: managers may acquire inventory for speculative reasons such as if they think prices are
going to increase in future.

 Following are the costs associated with Inventory

1. Ordering: fixed per transaction
2. Carrying: Cost of holding the inventory (insurance, interest, rent)
3. Stock-out: Emergency ordering, Profit foregone due to lost sales

 There are two basic approaches to manage the inventory

1. Economic Order Quantity
2. Just-in-Time

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Inventory Management (Contd.)

1. Economic Order Quantity – Reorder Point (EOQ-ROP)

• It requires determining the level of inventory at which new inventory is ordered.
• This method is based on expected demand and the predictability of demand.

Inventory

√
Level
2𝑈 × 𝑃
𝐶=
𝑆
Where, Economic
C = Optimum Inventory to be ordered order quantity
U = Periodic Inventory consumption
Safety
P= Fixed Ordering Cost per transaction stock

order

order

order

order
S =Opportunity cost of one rupee per period
Time

2. Just – in-Time (JIT)

• A system that minimizes ‘in-process inventory stock’ by ordering a stock only at the last moment
• Objective is to keep minimum amount of funds blocked in inventory

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Managing Accounts Payable

 Accounts Payable are the amounts due to suppliers and services that have not been paid

 Trade credit involves delayed payment with a discount for early payment

“2/10, net 30” indicates that a 2% discount is available if the account is paid within 10 days.
Otherwise full amount is due in 30 days

( )
( 365/ Number of days beyond discount period )
Discount
Cost of trade credit= 1+ −1
1− Discount
 Accounts payable management is important as this is a source of WC for the firm
If a firm pays its payables before their due date, cash is used unnecessarily. A too long a period in accounts
payable would spoil the relationship with the suppliers and could entail high interest costs (compared to other
sources of short term financing)

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Short Term Funding / Borrowings

 Overall short term financial strategy should focus on maintaining a sound liquidity position. Major objectives
of a short term borrowing strategy include:
1. Ensuring there is enough capacity to handle peak cash needs
2. Maintaining sufficient (more than one) sources of credit
3. Obtaining cost-effective sources of finance

 A short term borrowing policy should include guidelines for:

1. Managing investments
2. Borrowing
3. Foreign Exchange
4. Risk management activities

 Factors to be considered in short term borrowing strategies

• Size and credit worthiness
• Sufficient Access
• Flexibility of borrowing options

 Borrowing strategies can be active or passive

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Sources of Short Term Funding – Banking Channel

1. Uncommitted line of credit - credit limit offered may be withdrawn / refused

2. Committed line of credit – bank commits the credit (reliable source)
3. Revolving line of credit – longer term committed credit line (very reliable source)
• Formal legal agreements
• Effective for multiple years
• Generally done for much larger amounts
• Amounts are spread out among more than one bank.

Companies with weaker financials may have to pledge assets as collateral. Short term financing is typically
secured with receivables or inventory and long term assets are secured with a claim on fixed assets. If the
bank has a blanket lien, this means that the bank has claim over all current and future firm assets as
collateral in case the primary collateral is insufficient, in case of default

4. Banker’s acceptance – guarantee from the bank that a payment will be made upon receipt of the goods
5. Factoring – sale of receivables at a discount
• Companies with weak financial positions
• Provides collateral in the form of an asset for the loan

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Computing the Costs of Borrowing

 The fundamental rule is to compare the total cost of borrowing by the total cash received adjusted for any
discounting or compensation balances.

Interest +Commitment fee

 Line of credit that requires a commitment fee Cost =
Loan 𝑎𝑚𝑜𝑢𝑛𝑡

Interest Interest
 Interest rate is stated as “all inclusive” Cost= =
𝑁𝑒𝑡 𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠 𝐿𝑜𝑎𝑛𝑎𝑚𝑜𝑢𝑛𝑡 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡

Interest + Dealer ′ s commission+backup cos 𝑡𝑠

 If there are dealer’s fee and backup costs Cost =
Loan 𝑎𝑚𝑜𝑢𝑛𝑡 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡

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Sources of Short Term Funding – Non-Banking Channel

 Non-banking finance companies – easier to avail but at a higher cost compared to bank
 Commercial papers - usually sold by high creditworthy companies

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 Knowledge Check

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Knowledge Check

1. For a firm if the operating cycle has increased but cash conversion cycle has remained the same then which
of the following is most likely to have increased.
A. Account Receivable
B. Average Inventory
C. Accounts payable
2. A company is offered trade credit terms of 2/10, net 60. The annualised cost of not taking the discount when
the invoice is paid on 50th day is
A. 20.2%
B. 22.2%
C. 20.4%
3. The invoice terms is given as: 3/15 net 90. If discount is not taken, there is some annualized cost of trade
credit. Which of the following is true?
A. For payment of invoice on 30th day, annualized cost is 16.98%. If discount is not taken in 15 days then company
should make the payment on the due date.
B. For payment of invoice on 45th day, annualized cost is 44.86%. If discount is not taken in 15 days then company
should make the payment on the due date, i.e. 90th day.
C. For payment of invoice on 60th day, annualized cost is 28.02%. If discount is not taken in 15 days then company
should make the payment on the due date, i.e. 60th day.

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Solution

 Solution: 1. C.
The operating cycle increase can be the result of an increase in either of average inventory or accounts
receivable or both. But even when operating cycle has increased, the cash conversion cycle has remained
the same which means that the accounts payable has definitely increased

 Solution: 2. A.
Annualized cost of not taking discount = ( 1+0.02/(1-0.02))^(365/50-10) -1 =20.2%

 Solution: 3. B.
For payment of invoice on 45th day, annualized cost is 44.86%. If discount is not taken in 15 days then
company should make the payment on the due date, i.e. 90th day.

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Knowledge Check

4. For a company, which of the following is least likely a source of primary liquidity ?
A. Trade on credit from vendors
B. Cash balances
C. Liquidating long lived assets
5. For a company ABC Ltd, based on following details the ratio of cash ratio to quick ratio is closest to:
• Cash..................................................$100,000
• Marketable Securities..........................$30,000
• Account Receivable.............................$20,000
• Inventory..............................................$50,000
13/15
A. 13/20
B. 15/13
6. Shaw Corporation purchased a product from Martinez Corporation for $10,000, terms 3/10, net/60. What is
the effective interest rate (round to 2 decimal places) associated with these terms?
A. 22.56%
B. 21.91%
C. 16.86%

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Solution

 Solution: 4. C.
A company’s primary sources of liquidity are the sources of cash which it uses in normal day to day
operations which include cash balances and trade on credit from vendors. Liquidating long lived assets is a
secondary source of liquidity.

 Solution: 5. A.
Cash ratio/Quick ratio = (Cash +Marketable securities)/ (Cash +Marketable securities + Account receivable)
= ( $100,000+$30,000)/( $100,000 +$30,000+ $20,000) = 13/15

 Solution: 6. A.
$10,000 x .03 = $300
365 / 50 = 7.3 (Simple interest used in place of compounding)
$300 / $9,700 = 3.09%
7.3 x 3.09% = 22.56%

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Knowledge Check

7. A company is looking for most reliable form of short term financing. Which one of the following lines of credit
should he choose?
A. Uncommitted line of credit
B. Committed line of credit
C. Revolving line of credit
8. Which of the following is a guarantee from the bank of the firm that has ordered the goods stating that a
payment will be done when goods are received:
A. Committed line of credit
B. Banker’s Acceptance
C. Commercial paper
9. Which of the following is not a characteristic of factoring?
A. It refers to the sale of account receivables at a discount from their face value.
B. The seller of the receivables is known as factor.
C. The factor takes the responsibility for collecting receivables and the credit risk.

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Solution

 Solution: 7. C.
Under Uncommitted line of credit a bank may extend offer of credit for certain amount but may refuse to lend
if circumstances change. Under committed line of credit a bank extends an offer of credit that it commits to
for some period of time. Revolving are more reliable and usually of longer terms than committed line of
credit.

 Solution: 8. B.
Commercial paper: An unsecured, short-term debt instrument issued by a corporation, typically
for the financing of accounts receivable, inventories and meeting short-term liabilities.
Committed line of credit: A committed credit line is a legal agreement between the financial institution and the
borrower outlining the conditions of the credit line.

 Solution: 9. B.
Factoring refers to the actual sale of account receivables at s discount from their face values. The buyer is
known as factor and he takes the responsibility for collecting receivables and the credit risk.

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Knowledge Check

10. A company is offered a trade discount 2/10 net 60 on its payables. The company can also avail of a short
term loan from other sources at 20%. Which of the following is the best accounts payables management
decision taken by the company?
A. The company should avail of the discount either on the 10th day or wait till the end of credit period to clear its
dues
B. The company should pay the invoice either before the 50th day or wait till the end of the credit period
C. The annualised cost of trade credit always exceeds the short term interest rate during the credit period, hence
the company should avoid the discount option

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Solution

 Solution: 10. A.

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