Companies have multiple short-term and long-term financing choices. Short-term funds without explicit interest rates are part of working capital management, for example: accounts payable. The goal of effective working capital management is to ensure that a company has adequate ready access to the funds necessary for day-to-day operating expenses.
Long-term funds raised through other debt and equity obligations are part of the firm’s capital structure. The goal of effective capital structure management is to balance the risks and costs of the firm’s long-term finances.
This reading covers:
Exhibit 1 from the curriculum shows the main internal and external sources of capital for a company.
|Financial intermediaries||Capital markets||Other|
|● After-tax operating cash flows
● Accounts payable
● Accounts receivable
● Inventory & marketable securities
|● Uncommitted lines of credit
● Committed lines of credit
● Revolving credit
● Secured loans
|● Commercial paper
● Public & private debt
● Hybrid securities – preferred equity, convertibles
● Common equity
Large profitable companies often use internal financing as the primary source of funds for financing growth.
Companies can generate internal financing from short-term operating activities in many ways such as:
Some important terms related to internal financing are:
Financial intermediaries can include both bank or non-bank lenders. The main type of financing options available through these sources are:
A company can also sell its accounts receivables to a lender, typically at a substantial discount. This is called a factoring arrangement. In an assignment arrangement, the company retains the collection responsibilities, whereas in a factoring arrangement, the company shifts the collection responsibilities to the lender.
Web-based lenders and non-bank lenders are recent innovations that operate primarily on the internet. They typically offer loans in relatively small amounts to small businesses in need of cash.
Commercial paper: Is a short-term, unsecured instrument typically issued by large, well-rated companies. It has maturities typically ranging from a few days to 270 days.
Debt vs. equity financing: The main differences between debt and equity obligations are summarized in Exbibit 2 of the curriculum.
|Legal Agreement||Company has a contractual obligation to debtholders||Shareholders are residual owners of the company|
|Claim Priority||Debtholder interest and principal payments have priority||Residual claimants to distributions and corporate assets|
|Distributions||Periodic, contractual interest payments and repayment of principal at maturity||Discretionary dividend payments declared by the Board of Directors|
|Taxation (some variation across jurisdictions)||Interest payments are tax-deductible expenses||Dividend payments and share repurchases are not tax-deductible expenses|
|Term||Stated term to maturity||No finite term|
|Voting Rights||Generally, no voting rights||Voting rights|
|Cost to Company||Generally lower cost to company||Generally higher cost to company|
|Investor Risk||Generally lower risk to investors||Generally higher risk to investors|
Long-term debt: Has a maturity of at least one year. Notes have maturities from one to ten years, and bonds have maturities of at least ten years.
Common equity: Represents ownership in a company. It is considered a more permanent source of capital.
Preferred equity: Are hybrid securities that have the characteristics of both bonds and common equity.
Other hybrid securities: Convertible debt and convertible preferreds are hybrid securities issued by companies and are convertible into a fixed number of the companies’ common shares.
Leasing obligations: A lease is a debt instrument where the asset owner (the lessor) gives another party (the lessee) the right to use the asset e.g., a property or equipment. In return, the lessee agrees to make a set of contractually fixed payments.
Firm-Specific Financing Considerations
General Economic Considerations
Liquidity is the extent to which a company is able to meet its short-term obligations using assets that can be readily converted into cash (by selling or financing).
Liquidity management refers to the ability of an organization to generate cash when and where needed.
Two sources of liquidity for a company are:
A company’s liquidity position is affected by cash receipts and the amount of cash it has to pay.
Drags on liquidity reduce cash inflows. For example, bad debts, obsolete inventory, uncollected receivables, etc.
Pulls on liquidity accelerate cash outflows. For example, earlier payment of vendor dues, etc.
Liquidity contributes to a company’s credit-worthiness. Credit-worthiness is the perceived ability of the borrower to pay what is owed in a timely manner despite adverse conditions. A high credit-worthy company is one that has the ability to make interest payments on a loan as they come due.
High credit-worthiness allows a company to:
Ratios used for assessing a company’s liquidity
Financial ratios can be used to assess a company’s liquidity as well as its management of assets over time. The commonly used ratios are:
|Current ratio||Current assets ÷ Current liabilities||The greater the current ratio the higher the company’s liquidity|
|Quick ratio||(Cash + Marketable securities + Receivables) ÷ Current liabilities||The higher the quick ratio the higher the company’s liquidity|
|Cash ratio||(Cash + Marketable securities) ÷ Current liabilities||The higher the cash ratio the higher the company’s liquidity|
|Receivable turnover||Credit Sales ÷ Average receivables||It is a measure of how many times, on average, accounts receivable are created by credit sales and collected on during the fiscal period.|
|Number of days of receivables||365 or days in period ÷ Receivable turnover||It tells the number of days on average the company takes to collect on the credit accounts|
|Inventory turnover||Cost of goods sold ÷ Average inventory||It is a measure of how many times, on average, inventory is created or acquired and sold during the fiscal period|
|Number of days of inventory||365 or days in the period ÷ Inventory turnover||It is the length of time, on average, that the inventory remains within the company|
|Payables turnover||Average day’s purchases ÷ Average trade payables||It is a measure of how long it takes the company to pay its own suppliers|
|Number of days of payables||365 or days in the period ÷ Payables turnover||It tells the number of days on average the company takes to make payments to its suppliers.|
|Cash conversion cycle||Days of inventory + Days of receivables – Days of payables||It measures the time from paying suppliers for raw materials to collecting cash from customers. The shorter the cycle, the better is the cash-generating ability of a company|