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Management of Short-Term Financing 707 Factoring A borrower can go a step further in financing with accounts receivable. Instead of simply using accounts receivable as collateral, the borrower can sell them outright to another party—called a factor—typically a bank or a commercial finance company. Selling the receivables—called factoring—may be done with or without recourse. In a factoring arrangement without recourse, the factor performs all the accounts receivable functions: evaluating customers’ credit, approving credit, and collecting on accounts receivable. If any of the accounts turn out to be uncollectible, the factor bears the bad debt. If a borrower has an arrangement with a factor with recourse and the borrower grants credit without permission from the factor, the borrower assumes responsibili- ties for collection of the account. There are basically two types of factoring, maturity factoring and con- ventional factoring. They differ with respect to when cash is received for the receivables. In maturity factoring, the customer sends cash to the fac- tor, who then sends the cash (less a commission) to the seller. In conven- tional factoring, the factor advances cash to the seller when the accounts are factored, and then keeps the customers’ payments as they come in. Factors charge a commission of 0.75% to 1.5% of the face value of the accounts receivable. In addition, if funds are advanced, as in the case of conventional factoring, the factor charges interest on those funds, usually at a rate of 2¹⁄₂ to 3% above the prime rate. Because fac- toring is a substitute for having accounts receivable personnel, whether a firm should use factoring requires comparing what it costs to operate the receivables function with the factor’s commission. Suppose a firm borrows using conventional factoring for its $10 million accounts receivable. And suppose the factor charges a fee of 1% of the face value of the receivables, payable up front, and interest at 3% over prime. If the prime rate is 12% APR, what does it effectively cost the firm to borrow under these terms for one month? If the factor lends the firm $10 million but then charges a fee of 1% at the beginning of the loan, the borrower has the use of only 99% of the $10 million, of $9.9 million. Interest is 3% over prime, or 15% a year. As the prime rate is an annual percentage rate, the monthly rate is 15%/12 = 1.25%. The interest is therefore 1.25% of $10 million, or $125,000. The effective cost over a month is: and the effective annual rate is: r $125,000 $100,000+ $9,900,000 0.0227 or 2.27%== 21-MgmtShort-Term Page 707 Wednesday, April 30, 2003 12:06 PM 708 MANAGING WORKING CAPITAL EAR = (1 + 0.227) 12 − 1 = 30.91% Inventory Inventory can also be used as collateral for financing since it is a fairly liquid asset. Not all inventory is of equal importance as security: The amount of funds loaned depends on how easy it is for the lender to turn the inventory into cash. In general, ■ standardized inventory is much better than specialized inventory. ■ nonperishable inventory is better than perishable inventory. ■ raw materials and finished goods are better than work-in-process. Types of Inventory Financing There are several different types of loan arrangements that involve inventory as collateral. These arrangements differ in terms of the con- trol that the lender has over the location and disposition of the inven- tory. A floating lien is the most flexible type of inventory loan. A floating lien gives the lender a lien on all inventory of the borrower—that is, all inventory is security for the loan. Therefore the security of the loan changes as the borrower buys and sells inventory. A chattel mortgage is a loan secured by specified inventory. In other words, inventory items are uniquely identified, such as by serial number, as collateral for the loan. The borrower retains title of the inventory. And although the borrower still owns the inventory, she or he cannot sell it unless the lender gives permission. This type of loan is best suited for inventory that consists of large, slow moving items. In a trust receipts loan, the borrower holds the inventory in trust for the lender. As the inventory is sold, the borrower keeps the proceeds in trust for the lender. This type of arrangement is also referred to as floor planning and is used often with auto dealerships. First, the bor- rower arranges a loan with the finance company. The borrower then orders and receives the inventory, with the finance company paying the supplier. As the borrower sells the inventory items, the borrower remits the payments to the finance company, reducing the amount of the loan. Because the finance company is counting on the borrower to maintain the inventory (keep it in good condition) and send the payments when sales are made, the lender must devise a way to monitor the borrower. In a field warehouse loan the lender has tighter control over the inventory. The collateral (the inventory) is kept in a separate, secured area within the borrower’s premises and is monitored by a field ware- house agent. This agent keeps control over the inventory in this area 21-MgmtShort-Term Page 708 Wednesday, April 30, 2003 12:06 PM Management of Short-Term Financing 709 and issues receipts to the lender, indicating the existence of the inven- tory. As the lender receives these receipts, she makes a loan based on the collateral value of the inventory. This arrangement is more expensive than the floating lien, chattel mortgage, and trust receipts arrangements because a third party—the field warehouser—must be compensated for his services. This arrangement offers the lender more peace of mind over the inventory. Even tighter control over collateral inventory is maintained in a public warehouse loan arrangement. In a public warehouse loan, collat- eral inventory is kept in a secured area away from the borrower’s pre- mises, such as in a public warehouse, and is only released to the borrower if the lender gives permission. The warehouser issues to the lender receipts (similar to the field warehouse arrangement) from which the lender acknowledges in the form of money loaned to the borrower. In this arrangement, the lender has title to the goods instead of the bor- rower. Cost of Inventory Financing Suppose a firm borrows $1,000,000 for one month under a field ware- housing arrangement. And suppose the interest rate on the loan is 12% APR. The interest on the loan is therefore 1% of $1,000,000, or $10,000. If the field warehouse charges a $5,000 fee, payable at the end of the month, the cost of this financing is: and: If the field warehouse charges the $5,000 fee at the beginning of the month, the cost for the month is more since effectively the firm has only borrowed $995,000: and: r $10,000 $5,000+ $1,000,000 0.0150 or 1.50%== EAR 1 0.0150+() 12 1– 0.1956 or 19.56%== r $10,000 $5,000+ $995,000 0.0151 or 1.51%== EAR 1 0.0151+() 12 1– 0.1970 or 19.70%== 21-MgmtShort-Term Page 709 Wednesday, April 30, 2003 12:06 PM 710 MANAGING WORKING CAPITAL EXHIBIT 21.9 Annual Cost of Short-Term Financing Alternatives, 1997–2002 Source: Federal Reserve Bank of St. Louis ACTUAL COSTS OF SHORT-TERM FINANCING The cost of short-term financing is a function of many factors, including ■ prevailing interest rates ■ creditworthiness of borrower (credit rating) ■ length of maturity of borrowing ■ level of seniority ■ collateral ■ backup line of credit The costs of different forms of financing vary, due to these factors. We can see the difference in the costs of several different forms of short- term financing in Exhibit 21.9, where the costs of several types of financing are shown, along with the rate on the 6-month T-Bill—the government’s cost of short-term financing. We use the T-Bill rate for comparison purposes since this is the rate on a short-term security with no risk of default—the U.S. government can always print more money to cover its debts. We see that bankers’ acceptance rates are higher than the T-Bill rates. This is because there is some default risk with acceptances. Com- 21-MgmtShort-Term Page 710 Wednesday, April 30, 2003 12:06 PM Management of Short-Term Financing 711 mercial paper rates are slightly higher than those for acceptances, since they are also considered to have little default risk yet may or may not be backed by a line of credit. The prime rate, which is what banks use as a base rate for their loans, is above the commercial paper rate, reflecting a generally greater risk associated with the bank loans relative to the com- mercial paper, which are issued by large, creditworthy corporations. SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS There are special borrowing arrangements for financial institutions such as commercial banks and securities firms in which the securities (partic- ularly, bonds) that they own or want to acquire are used as collateral. The arrangement is called a repurchase agreement. A repurchase agreement, commonly referred to as a repo, is the sale of a security with a commitment by the seller to buy the same security back from the purchaser at a specified price at a designated future date. The price at which the seller must subsequently repurchase the security is called the repurchase price and the date that the security must be repur- chased is called the repurchase date. Basically, a repurchase agreement is a collateralized loan, where the collateral is the security that is sold and subsequently repurchased. The term of the loan and the interest rate that the securities firm agrees to pay are specified. The interest rate is called the repo rate. When the term of the loan is one day, it is called an over- night repo; a loan for more than one day is called a term repo. The transaction is referred to as a repurchase agreement because it calls for the sale of the security and its repurchase at a future date. Both the sale price and the purchase price are specified in the agreement. The difference between the purchase (repurchase) price and the sale price is the dollar interest cost of the loan. The following illustration describes the mechanics of a repo. Sup- pose a securities firm wants to purchase for 10 days $10 million of a particular Treasury security using a repo to finance the purchase. Sup- pose further that a customer of the securities firm has excess funds of $10 million to invest for 10 days. (The customer might be a municipal- ity with tax receipts that it has just collected, and no immediate need to disburse the funds, or a mutual fund with cash it wants to invest for 10 days.) The securities firm would agree to deliver (“sell”) $10 million of the Treasury security to the customer for an amount determined by the repo rate and buy in 10 days (“repurchase”) the same Treasury security from the customer for $10 million the next day. Suppose that the over- 21-MgmtShort-Term Page 711 Wednesday, April 30, 2003 12:06 PM 712 MANAGING WORKING CAPITAL night repo rate is 3%. Then, as will be explained below, the securities firm would agree to deliver the Treasury securities for $9,991,667 and repurchase the same securities in 10 days for $10 million. The $8,333 difference between the “sale” price of $9,991,667 and the repurchase price of $10 million is the dollar interest on the financing. The following formula is used to calculate the dollar interest on a repo transaction: Dollar interest = (Dollar principal) × (Repo rate) × (Repo term/360) Notice that the interest is computed on a 360-day basis. In our example, at a repo rate of 3% and a repo term of 10 days, the dollar interest is $8,333 as shown below: $10,000,000 × 0.03 × 10/360 = $8,333 The advantage to financial institutions of using the repo market for borrowing on a short-term basis is that the rate is lower than the cost of bank financing. The reason for this is that the borrowing is secured by the collateral and if the market value of the security declines, the securi- ties firm would be required to put up more collateral or return cash. Four final points about repos. First, there is not one repo rate. The rate varies from transaction to transaction. One factor that affects the repo rate is the term of the borrowing. As explained in Chapter 3, there is a term structure of interest rates. The same is true in the repo market. Second, in practice the amount loaned will not be equal to the mar- ket value of the securities. Instead, less will be loaned. By doing so, the lender reduces credit risk because the loan is overcollateralized (i.e., the amount lent is less than the market value). The difference between the market value of the security and the amount loaned is called the haircut. Third, one can be confused by whether a repurchase agreement is a financing arrangement or an investment vehicle if one does not under- stand which side of the transaction a party is on. For example, in our illustration we demonstrated how a financial institution can use a repo to finance the purchase of a security. From the perspective of the cus- tomer that loaned the funds, the transaction is a short-term investment. Consequently, repos are referred to as money market instruments because they have a maturity of less than one year. Finally, some financial institutions earn income by borrowing and lend- ing the same security in a repo transaction with the same maturity. This is referred to as running a “matched book.” For example, suppose that a secu- rities firm enters into a term repo of 10 days with a mutual fund and lends funds to a commercial bank for 10 days using a term repo. The securities 21-MgmtShort-Term Page 712 Wednesday, April 30, 2003 12:06 PM Management of Short-Term Financing 713 involved in both transactions are the same. If the repo rate on the repo trans- action with the mutual fund is 3.30% and the repo rate on the repo transaction with the commercial bank is 3.25%, then the financial institu- tion is earning a spread of 0.05% (5 basis points). SUMMARY ■ Short-term financing includes trade credit, bank financing, money mar- ket securities, and secured financing. ■ You must calculate the effective cost of short-term financing arrange- ments in order to compare them. Putting the cost of financing on an effective annual basis facilitates this comparison. To calculate an effec- tive cost, you must consider any discount interest, compensating bal- ance requirements, and fees. ■ Trade credit arises out of ordinary business transactions, where suppli- ers permit firms to pay at some later date. The cost of trade credit is from any discount not taken. ■ Accounts payable management requires us to compare the cost of trade credit with the cost of other forms of credit. We also must weigh the benefits of paying our accounts later with the costs late payments will have in the form of our relationship with suppliers. ■ Bank financing comes in many forms, including single payment loans, which may arise from simple lending arrangements or from promises to lend in the form of lines of credit, revolving credit agreements, or let- ters of credit. ■ Short-term financing can also be obtained using loans that create mar- ketable securities, such as commercial paper and bankers’ acceptances. Because these securities have lower risk, due to the creditworthiness of the parties that issue the security and backup credit by banks, they are also lower cost ways of financing. ■ There are a variety of secured financing arrangements, including accounts receivable (assignment and factoring), inventory (floating liens, chattel mortgages, trust receipts, and warehousing), and market- able securities (repurchase agreements). ■ Accounts receivable may be used as collateral in a loan. In the assign- ment of receivables, the lender loans funds with the accounts receivable as collateral. As payments are made on the accounts (generally directly to the lender), the lender accepts these as repayment of the loan. In fac- toring, the borrower sells the accounts receivable to the lender, the factor. ■ There are several types of loans that involve inventory as collateral. These loans differ in terms of the control that the lender has over the 21-MgmtShort-Term Page 713 Wednesday, April 30, 2003 12:06 PM 714 MANAGING WORKING CAPITAL inventory, ranging from little control (i.e., a floating lien) to tight con- trol (field warehouse loan). ■ The costs of short-term financing depend on many features of the loan, including the creditworthiness of the borrower, the amount borrowed, any backup line of credit, and the maturity of the loan. Generally, com- mercial paper and bankers’ acceptances have lower costs than bank loans and loans secured with accounts receivable or inventory. ■ A repurchase agreement is a specialized financing arrangement used by financial institutions to finance their purchase of securities. QUESTIONS 1. Consider a single payment loan with interest of 10% and a discount loan with a discount of 10%. If the loan amounts and the loan peri- ods are the same for both loans, which loan has a higher effective cost of financing? Why? 2. If a bank states 5% interest on a 360-day basis, is this stated rate less then, equal to, or more than 5% interest on a 365-day basis? Why? 3. Consider two loans with equal maturity and identical face values: a discount loan that has a discount of 10% and a single payment loan with a 10% compensating balance requirement. Which loan has the higher interest rate? Explain. 4. Consider two loans with equal maturity and identical loaned amounts: a discount loan that has a discount of 10% and a single payment loan with no interest but an origination fee of 10%. Which loan has the higher interest rate? Explain. 5. Explain the advantages and disadvantages of stretching payments on trade credit. 6. There are different ways a firm may use its inventory as collateral in financing arrangements. How do these alternative arrangements differ? 7. OEA, Inc., a manufacturer of aerospace and automobile products, at the end of their 1992 fiscal year-end had a $2.5 million line of credit, with the interest rate equal to the lending institution’s prime interest rate minus 0.5%. OEA is required to keep a compensating balance on deposit with the lending institution equal to 5% of the line of credit, plus add 5% of any usage. [Source: OEA 35th Annual Report—1992, page 14]. a. What do you need to consider in determining OEA’s cost of the line of credit? b. How does the compensating balance affect OEA’s cost of borrowing? 8. If there is no stated interest on trade credit, how can there be a cost to trade credit as a source of short-term financing? 21-MgmtShort-Term Page 714 Wednesday, April 30, 2003 12:06 PM Management of Short-Term Financing 715 9. In using trade credit, if there is a lower effective cost of paying later, what incentive is there to pay early? What incentive is there to pay within the net period? 10. Explain how the assignment of receivables differs from factoring. 11. Distinguish between maturity factoring and conventional factoring of accounts receivable. 12. Calculate the effective annual rate that corresponds to each of the following alternative financings’ annual percentage rates: 13. Calculate that effective annual cost of each of the following trade credit terms and payment dates: a. 1/10, net 30, paying on day 20. b. 2/10, net 40, paying on day 30. c. 3/15, net 60, paying on day 60. d. 5/15, net 50, paying on day 50. 14. Calculate the effective annual cost of trade credit for the terms of 1/ 10, net 40, if payment is made: a. 9 days after the sale. b. 11 days after the sale. c. 20 days after the sale. d. 30 days after the sale. e. 40 days after the sale. 15. What is the effective annual cost of a single payment loan that requires interest of 6% after three months? 16. What is the effective annual cost of a discount loan that has a dis- count of 5% and a loan period of four months? 17. Calculate the effective annual cost of a six-month loan of $100,000 that has a 7% interest rate, and: a. no compensating balance nor loan origination fee. b. a 20% compensating balance and no loan origination fee. c. a 20% compensating balance and a loan origination fee of $1,000, taken as a discount. 18. Calculate the effective annual cost of a three-month loan of $1 mil- lion that has a 16% APR, and: a. no compensating balance nor loan origination fee. Alternative APR Frequency of Compounding A 12% annually B 12 semiannually C 18 monthly D 10 weekly E 5 quarterly 21-MgmtShort-Term Page 715 Wednesday, April 30, 2003 12:06 PM 716 MANAGING WORKING CAPITAL b. a 10% compensating balance and no loan origination fee. c. a 10% compensating balance and a loan origination fee of $1,000, paid at the beginning of the loan. 19. The Dieu Company had sales of $1 million in 1996, with 60% of its sales made on credit. If the average accounts payable are $100,000, what is Dieu’s accounts payable turnover? 20. At the end of 1996, Golden Motors Corporation had $10 billion of accounts payable. If this balance is representative of GM’s payables, and if it takes GM 30 days to pay on its accounts, how much did GM have in credit purchases during 1996? 21. Suppose that a factor is willing to lend you $6 million for one month, using your firm’s accounts receivable as collateral. If the annual percentage rate on this loan is 12%, what is the effective interest rate? If the factor charges an up-front fee of 2%, what is the effective annual cost of this loan? 22. The Cash Poor Company is considering using its $1 million of accounts receivable to secure financing for the next month. Cash Poor has approached two financing firms, each offering different arrangements. Firm A is willing to lend Cash Poor 75% of the face value of the receivables at 60 basis points above the prime rate. Firm B is willing to factor Cash Poor’s receivables, advancing 75% of the receivables, collecting a fee up front of 1% of all receivables, and charging interest at 30 basis points above the prime rate. In the case of Firm A’s arrangement, Cash Poor continues with its evalua- tion and collection of credit, but in the case of Firm B’s arrange- ment, Firm B performs all the credit functions, saving Cash Poor an estimated $10,000 over the next month. If the prime rate is 12% APR, which arrangement is less costly for Cash Poor? 23. What is the effective cost of financing for a six-month inventory field warehouse loan of $100,000 that requires interest of $6,000 to be paid at the end of six months and a warehouse fee of $5,000 to be paid at the beginning of the loan period? 24. A firm is considering using a field warehousing arrangement as part of its short-term financing. The field warehouse requires a once-a- year payment of $10,000, paid at the beginning of the year, no mat- ter how much the firm borrows. Interest on the loan is a single pay- ment of 10% per year, paid at the end of the year. What is the effective annual cost of borrowing using field warehousing if the amount borrowed is: a. $150,000? b. $200,000? c. $300,000? d. $500,000? 21-MgmtShort-Term Page 716 Wednesday, April 30, 2003 12:06 PM [...]... whose management developed a system of breaking down return ratios into their components.2 Let’s look at the return on assets of Fictitious for 19 98 and 1999 Its returns on assets were 20% in 19 98 and 18. 18% in 1999 We can decompose the firm’s returns on assets for the two years, 19 98 and 1999, to obtain: Year Basic Earning Power Operating Profit Margin Total Asset Turnover 19 98 1999 20.00% 18. 18 22.22%... repurchase agreement? PART Six Financial Statement Analysis CHAPTER 22 Financial Ratio Analysis n this chapter, we introduce you to financial ratios—one of the tools of financial analysis In financial ratio analysis we select the relevant information—primarily the financial statement data and evaluate it We show how to incorporate market data and economic data in the analysis and interpretation of financial... - = $17 ,80 8 per day 365 days In other words, Fictitious incurs, on average, a cost of producing goods sold of $17 ,80 8 per day Fictitious has $1 .8 million of inventory on hand at the end of the year How many days’ worth of goods sold is this? One way to look at this is to imagine that Fictitious stopped buying more raw materials and just finished producing whatever was on hand in inventory,... earnings before interest and taxes (EBIT) (also known as operating earnings) to total assets: Earnings before interest and taxes Basic earning power = Total assets For Fictitious Corporation, for 1999: $2,000,000 Basic earning power = = 0. 181 8 or 18. 18% $11,000,000 For every dollar invested in assets, Fictitious earned about 18 cents in 1999 This... the management of the firm and to predict future performance, knowing the source of these returns is valuable Let’s take a closer look at the return on assets and break it down into its components: measures of activity and profit margin We do this by relating both the numerator and the denominator to sales activity Divide both the numerator and the denominator of the basic earning power by sales: 726 FINANCIAL. .. financial ratio analysis, warning you of the pitfalls that occur when it’s not done properly Financial analysis is one of the many tools useful in valuation because it helps the financial analyst gauge returns and risks We begin the analysis with a fictitious firm as our example, allowing us to use simplified financial statements and allowing you to become more comfortable with the tools of financial analysis After... performance and financial condition: 1 Return on investment 2 Liquidity 3 Profitability Financial Ratio Analysis 723 4 Activity 5 Financial leverage There are several ratios reflecting each of the five aspects of a firm’s operating performance and financial condition We apply these ratios to the Fictitious Corporation, whose balance sheets, income statements, and statement of cash flows were discussed in Chapter 6 and. .. declined from 19 98 to 1999, yet asset turnover improved slightly, from 0.9000 to 0.9091 Therefore, the return-on-assets decline from 19 98 to 1999 is attributable to lower profit margins The return on assets can be broken down into its components in a similar manner: 2 American Management Association, Executive Committee Control Charts, AMA Management Bulletin No 6, 1960, p 22 727 Financial Ratio Analysis ... 56.00% 45.45% 2.2727 1 .83 32 We see that the return on equity decreased from 19 98 to 1999 because of a lower operating profit margin and less use of financial leverage We can decompose the return on equity further by breaking out the equity’s share of before-tax earnings (represented by the ratio of earnings before and after interest) and tax retention percent:  Earnings before interest and taxes  Sales... power = 18. 18% Return on assets = 10.91% Return on equity = 20.00% These return-on-investment ratios tell us: Financial Ratio Analysis 725 ■ Fictitious earns over 18% from operations, or about 11% overall, from its assets ■ Shareholders earn 20% from their investment (measured in book value terms) These ratios do not tell us: ■ Whether this return is due to the profit margins (that is, due to costs and revenues) . interest and taxes Total assets = Basic earning power $2,000,000 $11,000,000 0. 181 8 or 18. 18% == 22 -Financial Ratios Page 723 Wednesday, June 4, 2003 12:06 PM 724 FINANCIAL STATEMENT ANALYSIS For. were 20% in 19 98 and 18. 18% in 1999. We can decompose the firm’s returns on assets for the two years, 19 98 and 1999, to obtain: We see that operating profit margin declined from 19 98 to 1999, yet asset. data and evaluate it. We show how to incorporate market data and economic data in the analysis and interpretation of financial ratios. Finally, we show you how to interpret financial ratio analysis,