Short-term funds are a temporary store of surplus funds that are not necessarily needed in a company’s daily transactions. If a significant part of a company’s working capital portfolio is not needed for daily/short-term transactions, then the money can be invested in a longer-term portfolio. Short-term working capital portfolios consist of securities that are highly liquid, less risky and shorter in maturity than other types of investment portfolios.
Generally working capital portfolios consist of short term government securities, and short term bank and corporate obligations. These are investments that can be converted into cash within 2-3 working days.
Yield on Short-term Investment
The yields on short-term investments are measured by:
Discount-basis yield =
Money market yield = = Holding period yield x
Bond equivalent yield = = Holding period yield x
F = face value
P = purchase price
T = number of days to maturity
Instructor’s tip: We have covered these yield measures in quantitative methods. The formula for bond equivalent yield below is different than the one we have seen in Quant which was BEY = 2 * semi-annual yield.
A 90-day $100,000 U.S. T-bill was purchased at a discount rate of 4%. Calculate the money market yield and bond equivalent yield.
Face value = $100,000; T = 90; discount rate = 4%
Using Equation 3:
Solving for P, we get P = 99,000
Money market yield = = = 4.04%
Bond equivalent yield = = = 4.097%
Strategies and Evaluation
The objective of investing in short-term funds is to earn a reasonable return while taking on limited credit and liquidity risk.
Companies must create an investment policy statement to achieve this objective. An IPS usually has the following structure:
Short term investing strategies can be either active or passive. Passive strategies focus on rules; safety and liquidity are prioritized. Active strategies are more aggressive and require constant monitoring. The different types of active strategies are as follows:
When evaluating a company’s short-term investment policy, one must see if the policy strategy meets the goals of the investment and if the credit ratings are neither restrictive nor liberal.
Accounts receivable gets recorded when a company sells a good or service to its customers on credit, i.e., customers do not pay for it at the time of sale. There is a trade-off between increasing sales by granting credit and uncollectible accounts (when the amount owed by customers is never paid back). If the credit terms are strict, then it hurts sales.
Three primary activities in accounts receivable management are:
Credit terms offered by a company depend on the type of customer, the customer’s creditworthiness, and credit terms offered by competitors. A customer’s creditworthiness is usually determined using a credit scoring model based on different factors such as prior late payments, ready cash, history of bankruptcy, etc. A company’s credit policy defines what types of credit to offer to what kind of customers.
The different types of credit terms available to customers include:
This section addresses the different ways in which customers make payments.
There are several ways of measuring accounts receivable performance; most deal with how effectively outstanding receivables can be converted into cash. A simple measure is number of days of receivables, but this does not consider the age distribution within the outstanding balance.
Earlier in this reading, we saw that receivables turnover = credit sales/average receivables and days of receivables = 365/receivables turnover. The problem with this approach is it does not indicate how much of receivables has been outstanding for how long, i.e., age distribution. For example, a company may have 50 percent of accounts receivable outstanding for 30-60 days while the other 50 percent may be outstanding for more than 90 days.
A common report used to monitor accounts receivable is the aging schedule. An aging schedule is a method of breaking down accounts receivable into different time periods for which they have been outstanding. That is, it lists accounts receivable into various groups of days outstanding like < 31 days, between 31 and 60 days, more than 60 days, and so on.
The advantage of this technique is that it helps the company in estimating how much of the receivables is potentially going to turn into bad debt, and for each time period how much money will not be collected at all. The longer a receivable is due, the higher the probability that it will never be collected.
The table below shows the aging schedule of accounts receivable for a company for three months: January to March. In part a), it is expressed in absolute terms and in part b), it is expressed as a percentage.
|a) Aging schedule (in $ millions)||b) Aging expressed as a percentage|
|Days outstanding||Jan||Feb||Mar||Days outstanding||Jan||Feb||Mar|
|< 31 days||2000||2120||1950||< 31 days||40%||39%||40%|
|31-60 days||1500||1650||1400||31-60 days||30%||31%||28%|
|61-90 days||1000||900||920||61-90 days||20%||17%||19%|
|> 90 days||500||700||660||> 90 days||10%||13%||13%|
The table below calculates the weighted average collection days for January given the average collection days for each grouping. The number of average collection days is multiplied by the weight to get the overall days for each grouping.
|Weighted Average Collection Period|
|Days outstanding||Avg. collection days||% weight||Days x weight|
|< 31 days||15||40%||6|
|> 90 days||120||10%||12|
Weighted average collection period for Jan = ∑ days * weight = 46.5. Remember that in the above table, data for average collection days under each grouping must be given in order to calculate the weighted average collection period. The challenge is that it is often not readily available.