Managing Accounts Payable Managing accounts payable involves negotiating the terms of purchases, as
Managing Accounts Payable Managing accounts payable involves negotiating the terms of purchases, as
well as deciding when to pay amounts due. Remember that accounts pay- able are the “flip side” of accounts receivable—your accounts payable are someone else’s accounts receivable. Your suppliers are trying to minimize their costs, in terms of funds tied up in accounts receivable and bad debts. Yet, at the same time they are extending credit to generate more sales.
1 We did not start graphing the effective cost in Exhibit 21.5 until 18 days from the sale because the effective interest cost is extraordinarily high for days 16 and 17.
EAR paying 16 days after the sale = (1.0101) 365 − 1 = 3,817% EAR paying 17 days after the sale = (1.0101) 182.5 − 1 = 526%
Management of Short-Term Financing
Firms try to set these policies with an eye on the policies of their competitors, so terms of credit are uniform within industries. However, if your firm is an important customer of a particular supplier, you may
be able to negotiate better terms of credit. In calculating the cost of trade credit, managers know:
■ If you pay within the discount period you are using free credit—you can delay payment by, say, ten days and pay the same as if you paid in cash on the date of purchase.
■ If you pay beyond the discount period, the later you pay, the lower the cost of credit.
While paying beyond the due date does reduce the cost of trade credit even further, some other issues arise. First, paying taxes, insur- ance, or license fees late may cost you dearly in legal costs and sanc- tions. Second, your creditors may impose penalties for payments beyond the due date. Third, if you consistently pay late, you may damage your relationship with a creditor. Also, paying beyond the due date may hurt your credit rating, making it more difficult or more expensive to borrow funds from banks or to purchase goods on credit in the future.
Aside from the legal costs and the indirect and direct costs of paying late, there is an important ethical issue: You agree to specific terms when you purchase the goods on credit. Intentionally (or even uninten- tionally) violating these terms is unethical business behavior.
It is important to monitor accounts payable to ensure that discounts are taken when possible and payments are made within the specified period. You can evaluate your accounts payable management by exam- ining the accounts payable turnover, a measure of how many times within a specific period the accounts payable are created and paid:
credit purchases Accounts payable turnover = --------------------------------------------
(21-5) accounts payable
The numerator is the total credit purchases made in the period. The denominator is a typical accounts payable balance over this period. The larger the turnover, the faster you are paying your accounts. For exam- ple, if you have $2,000,000 of credit purchases in a year and your end- ing balance in accounts payable (using the ending balance as typical accounts payable) is $200,000, the turnover is 10 times:
$2,000,000 Accounts payable turnover = ------------------------------ =
10 times
MANAGING WORKING CAPITAL
A high turnover may be good news or bad news: good news since you are probably establishing goodwill with your suppliers by paying quickly; bad news if you are not taking discounts but paying your bills before they are due. A low turnover may be good news, since you are stretching your payments out, lowering the effective cost of trade credit; bad news if you are paying beyond the due date, which may harm your credit standing.
Deciding whether a specific accounts payable turnover ratio is good news or bad news requires a bit more information. You can learn more about our payable management by calculating how long, on average, it takes us to pay. If you know the accounts payable you generate on a typical day and your typical balance of accounts payable, you can calcu- late the number of days’ worth of payables you have in accounts pay- able. The number of days in accounts payable is calculated as:
accounts payable No. of days in accounts payable = ----------------------------------------------------------------------------- (21-6)
average daily credit purchases If total credit purchases for the year are $2,000,000, your average
daily credit sales are $2,000,000/365 = $5,479. This implies that the number of days in your accounts payable balance is $200,000/$5,479 per day 36.5 days. This tells us that it takes, on average, 36.5 days to pay your accounts. Is this good or bad? It depends on your credit terms. If your credit terms all have net days of 30, then having 36.5 days in your ending balance tells you that you are, on average, paying late. If your credit terms all have net days of 60, then having 36.5 days tells you that you are, on average, paying too early.
If the credit terms you face are varied, it is difficult to evaluate the number of days in accounts payable. A more detailed breakdown of accounts payable is necessary. One breakdown is to classify it into three groups:
■ Payables that are still within the discount period ■ Payables that are beyond the discount period, yet are not overdue ■ Payables that are overdue
Once you have this classification, you can focus on why each of the accounts payable is not paid when due and why discounts were not taken. This also allows you to plan for discounts that can be taken in the near future.
Another classification scheme is to “age” the accounts payable; that is, classify the accounts by the number of days since the purchase. This
Management of Short-Term Financing
breakdown allows you to identify the older accounts payable, as well as to plan ahead for the ones that must soon be paid.
Accounts payable management is a balancing act: The cost of trade credit must be balanced against the cost of alternative sources of financ- ing. For example, if bank loans cost effectively 10% per year, should the firm borrow from the bank or use trade credit with terms of 1/15, net 30? Answer: the bank, since it costs less (10% versus 27.706%). But many times, especially for small businesses, bank loans may not be available and trade credit is the only source of financing the purchases.
Bank Financing Banks lend money to firms under different financing arrangements. The
financing arrangement may be straightforward, such as a single payment loan. Or a firm may obtain from a bank its promise to lend, such as a line of credit or revolving credit.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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