Financial Management and Factoring - Essay Example

Financial Management Case Calculate the benefit to the company of the two options: Option A involves the use of factoring, a system where a third-party organisation takes charge of credit collection in exchange for advancing a fixed percentage of the total receivables. Option B involves giving trade debtors who pay within thirty days a discount of one percent of the invoice amount. Each option has its own set of net costs and benefits to the organisation that we computed. Table 1 is a summary of the data on the case, the costs to Raphael Ltd of its current working capital management process and the computation of the benefits of both options. The findings are as follows: The current collection system is inefficient as trade debtors do not pay on time and extend the terms of payment from the agreed thirty to the actual fifty days. Raphael Ltd is spending 76,000 annually, equivalent to 3.2 percent of total credit sales, for trade debtor financing, bad debts, and overhead. Using Option A (factoring), Raphael Ltd can save at least 60,000 annually by allowing a third-party factoring company to handle the company's invoicing and collection activities. Using Option B (discounts), Raphael Ltd can save an additional 8,800 annually, despite the 9,600 cost of discounts, by lowering bad debts by 0.5 percent from the present to 1.0 percent of annual credit sales and saving the cost of trade debt financing through better collection. Enclosed report to the Board explains these with recommended working capital management improvements. Letter to the Board of Raphael Ltd from the Financial Manager: Working Capital Management One of the functions of financial management is to ensure that the company has enough cash to finance our operational requirements, that this cash is secured at the lowest possible cost, and that any idle cash we do not need is invested to earn the highest possible return. This is called working capital management. Working capital is the cash that is readily available to the organisation. This can be derived from the corporation's balance sheet by subtracting our current liabilities (short-term organisational commitments that needs cash payments) from our current assets (company resources that can be converted into cash in the short-term). These assets and liabilities are to be cashed or spent in the ordinary course of business; that is, we do not have to liquidate our company just to raise the cash we need, and neither do we have to pay all our long-term debts now. Working capital basically is a measure of how we manage our collections and our costs. Good working capital management, by lowering costs and maximising collections, contributes to maximising shareholder value, which is one of the Board's primary duties. An analysis of our current practices in this aspect of financial management has revealed the following problems: Trade receivables have increased from the desired thirty days to the actual fifty days. Bad debts have reached 1.5 percent of total sales. We are spending 76,000 annually, equivalent to 3.2 percent of sales, for trade debt or receivables financing, bad debts, and overhead. We have studied two options to manage our working capital that can bring down our costs and bring up our collections. Summary Course of Action We have looked at two options: Factoring (Option A) and Discounting (Option B). We summarise our findings as follows: Comparison of two options and current system Current system Trade debts from collections 40,000 Bad debts 36,000 Annual cost of debts: 76,000 Option A: Factoring Trade debts from collections 22,000 Service charges 48,000 Savings on bad debts (36,000) Savings from factoring (18,000) Annual cost of debts: 16,000 Annual savings from Option A: 60,000 Option B: Discounting Trade debt savings 6,400 Savings from collected bad debts 12,000 Cost of discounts (9,600) Annual savings from Option B: 8,800 Total savings from Options A and B: 56,800 We have calculated that factoring will save us 60,000 annually. Discounts will save us an additional 8,800 by bringing down our bad debts and trade debts costs, even if these discounts will cost us initially 9,600. If we use both options, we can save 56,800 each year, equivalent to 2.4 percent of sales. Note that combining the two options will give us a lower figure for total savings because if we use the Discounting option together with Factoring, the elimination of bad debts from availing of the latter (Factoring) option will give us only the benefit of trade debt savings from the former (Discounting) option. This means that if we want to maximise our savings, we can decide to selectively offer discounts only to those customers who would change their payment patterns and shorten the number of days it takes them to pay. This will increase our savings from early payments. If we can increase the number of on-time payers to 44 percent instead of just 40 percent, the discounts and savings will be balanced, and we can maximise the over-all savings from combining the two options. Aside from the savings, another advantage of factoring and improved collections is that it improves the company's cash position. Unlike in the past when we have to wait for at least thirty days before we start getting most of the collections, we are assured of getting the cash from the Factor (a company that buys receivables from companies like ours) equivalent to eighty percent of our trade debtors. This service is not for free, of course, and we have to pay for it. As you can see from the summary, however, the end result is good for the company. Advantages of Factoring What does it cost us to secure the services of a Factor First, we have to outsource our whole collection function and sales ledger monitoring to them. This will allow the Factor to manage the invoicing of our customers once a sale is made. This results in savings for the company, because the Factor will take over this function for us. We can re-deploy our existing employees doing these functions to other departments where they can be useful. We can save 18,000 yearly from this. Second, we pay the Factor a service charge of two percent of total sales each year, amounting to 48,000. Third, we have to pay the Factor for trade debtors who do not pay within thirty days at the rate of eleven percent per annum of the balance. We computed that this would only cost us 22,000 on the advanced amounts throughout the year. Fourth, we can eliminate bad debts from the use of a Factor. This practice, called non-recourse factoring, protects our revenues at the reasonable price of two percent of the total value of our invoices, which is the service charge we pay. We find the fee reasonable because the trade-off is that we save money that we currently pay for our overdraft on trade debts. Finally, factoring allows us to raise eighty percent of our outstanding invoices, which is better for our working capital management compared to the sixty percent maximum that we are able to get from our bank overdrafts. This gives us more leeway for our operational expenses and eases up our financing burdens. Disadvantages of Factoring There are some disadvantages of Factoring that we also need to address. First, we are outsourcing our credit and collection system. Since we are doing this for the first time, the concern is whether this will work or not, and if it does not, what do we do next The only alternatives are first, to get our credit and collection system back on track and start again after recovering our sales invoice database from the Factor, or second, to transfer to another Factor. In both cases, our working capital balances can get negatively affected. In order to address this potential problem, we are designing a back-up system so that any future change will not cause major disruptions beyond what we can reasonably manage. Second, some of our customers may prefer to deal with us instead of a Factor. To address this, we have discussed our policies and procedures carefully with the Factor and with our major customers, after which we do not foresee any major problems in future. Third, one of the conditions of non-recourse factoring is the pre-approval of customers by the Factor to ensure that no single customer accounts for a large portion of receivables. This is part of their procedures against major payment defaults that may cause delays in future, but this too has been discussed with the Factor and we have agreed on what we should do to avoid these delays. Other Working Capital Management Techniques Factoring and discounting are not the only working capital management techniques we can use in Raphael Ltd. There are several others that companies routinely use, and we are currently looking at each of these for application in our operations. Any good working capital management strategy must maintain the optimum balance of current assets (cash and bank deposits, inventory, debtors, and receivables) and current liabilities (bank overdrafts, creditors, and payables). This optimum balance is reached by making sure that funds are kept where their opportunity to earn is highest. This is accomplished by a combination of bank interest earnings, investments in other assets, or by paying off some liabilities. There is no single way to manage working capital, since each of our departments use capital differently. For example, marketing and sales want to give discounts to gain market share, accounting want the funds in the least risky investments, finance wants to keep those funds in high-return but high-risk instruments, operations want to use the funds in more advanced equipment, and personnel want it invested in people. Allocating the flow of capital, more especially working capital, is one of the jobs of Raphael Ltd's management team. What we constantly have in mind is that working capital management is only a means to maximise shareholder value. There are several ways of doing this. Managing Inventories Inventories or stocks are raw materials, work in progress, or goods ready to be sold. They represent working capital that has been spent and waiting to be turned into cash at a profit. Proper inventory management is a good strategy for managing working capital by turning stocks into cash as quickly as possible, ensuring that inventory does not diminish in value through losses, pilferage, damage, or by incurring high storage cost that raise its selling price beyond what the market can afford. If inventory is too high, costs can also be high; if too low, it can still cost high because of lost sales, delayed services, added freight and order costs, and loss of quantity discounts. By using mathematical models and practices like the Economic Reorder Quantity, Pareto Optimality, and Just-in-time (JIT) production management, we can improve our inventory management systems and make our capital work more efficiently. Minimise Trade Debts Customers who owe us money (trade debts) for goods they have bought are called trade debtors. Our objective in debtor management is to minimise the number of days between the sale and the collection of payment. Trade debts cost money in the form of opportunity cost (our cash is not available for our own us) and, if the debt is not paid, it becomes a bad debt, lost revenue, and wasted capital. Aside from offering cash discounts and factoring, we can manage trade debts by asking for payments before delivery, setting credit limits, and requiring deposits or progress payments. There are also post-sale strategies like the use of financial ratios to analyse the aging of receivables, established collection procedures, and legal action. Managing Creditors Creditors are suppliers who have provided our company with goods but who have not yet been paid. We owe them money, and these accounts payable are included in our short-term liabilities. In the same way that some of our customers see us as a source of free credit, since they can re-sell or use the goods they bought from us without having to pay us immediately, we also do the same with our suppliers. Here, we also try to minimise costs so we try to delay the payment up to the day they fall due. This makes good business sense, because they may delay deliveries if we do not pay them on time, or they may tell the industry about how bad we are with our payments, thus giving our bad trade debtors a reason for doing the same with us. There are new systems like electronic or Internet payments that can be more convenient for us as sellers and buyers of goods and services. We are looking into this to further bring down our costs. Cash at Hand and in the Bank Cash management can be crucial for working capital management. This is why we at Raphael Ltd do cash forecasting, balance management, and cash administration. Cash forecasting is a regular projection of cash flows within the company, showing where the cash will come from and where it will be used over a time period. At a glance, management can determine what the expenditures and receipts are and what financing decision is most appropriate: borrow, delay some payments, accelerate collections, or use the cash at hand. Meeting the payroll and paying our creditors are priorities in our cash forecasts. Balance management allows us to determine whether our cash balance is earning the most it can. For example, some companies with global subsidiaries lend surplus cash to each other instead of borrowing funds from a third party. We are looking at using mathematical models like the Miller-Orr cash balance model and trade credit analysis techniques to ensure that our working capital is earning at its optimum capacity. Cash administration means that collections are processed and placed in the bank, or invested in a financial instrument that earns higher rates, as quickly as possible. This aspect includes minimising cash floats (petty cash and cash advances) as much as possible, using them only where they are absolutely necessary, as in field offices or in the far reaches of our distribution network. Other ways we are looking into are booking of revenues before they are earned, adjusting current portions of long-term liabilities, and prepayments to creditors. There are different ways of managing working capital with the twin objectives that our operations have the cash they need to function according to our organisational strategies, and that our capital, of which cash is only one component, is earning as much as possible, without waste. Good financial management allows us to use capital efficiently and contribute to maximising shareholder returns by getting the highest returns at the lowest costs. Critical Analysis of Working Capital Is it possible for a company to optimise its working capital position In order to answer this question, we need to define what working capital is and what optimisation means. Mathematically, working capital can be represented by the following equation: Working Capital = Current Assets - Current Liabilities Where: Current Assets = Cash + Bank + Inventory + Debtors + Creditors Current Liabilities = Overdrafts + Creditors + Payables + other liabilities Given the equation above, it is possible to optimise the company's working capital position by setting targets and making adjustments in each of the nine variables that make up current assets and current liabilities. Each item incurs different sets of potential incomes and costs. Cash in bank can earn something, but cash turned into inventory may earn higher returns once it is sold, even if it costs money to store, deliver, and sell in the marketplace. Debtors and creditors can also be adjusted, but as we showed above, we can treat them in different ways, since every company is both a debtor and creditor, and given its size it may be able to dictate the rules of business. The current emphasis on supply chain management is, in fact, a part of optimising working capital management. Supply chain management, by cutting down on delivery times and inventory storage costs, aims to shorten the time it takes to convert unpaid raw material into collected revenue. Another ripe area for working capital optimisation is enabling financial resources, mainly cash and receivables, to earn higher rates or to cut down potential losses. The popularity of hedge funds, mutual funds, and financial instruments like derivatives allow finance managers to maximise the returns on their cash holdings or other revenues, hedging these against losses from foreign exchange or interest rate fluctuations. There are several derivatives - futures, forwards, swaps, and options - being bought and sold in the financial markets with this objective. Several of these instruments are complex and demand familiarity and prudent judgment for their use. Like any other product in the financial market, it is important that these are rightly priced to avoid overpaying for the risks we want to protect our company from, and to ensure that the company only suffer from transaction losses that are reasonable. The company can also optimise its working capital position by managing the liabilities side of the balance sheet, more specifically its liabilities for which it is exposed to what is called interest rate risk and, if it borrows in a foreign currency, currency risks. Again, several companies use derivatives to lessen these risks, with the same objective of maximising shareholder value by minimising losses. Several other companies retire high- rate debts for lower-rate ones from time to time depending on the level of interest rates in the market. All these efforts are designed for the same purpose of optimising working capital. Are we becoming too obsessed with maximising working capital Perhaps, but since cash (specifically, free cash flow) is one of the measures for share-price determination for a publicly-held firm, and investment analysts or potential investors use cash flow to calculate the market value of any company, publicly-held or not, the drive to manage working capital more efficiently will continue. Cash is still king and finance managers must listen. Bibliography: Brealey, R.A. and Myers, S.C. (2002). Principles of Corporate Finance (7th ed.). New York: McGraw Hill. Eiteman, D.K., Stonehill, A.I., and Moffett, M.H. (2004). Multinational business finance (10th ed.). New York: Addison-Wesley. Elton, E.J., Gruber, M.J., Brown, S. J. and Goetzmann, W. N. (2003). Modern Portfolio Theory and Investment Analysis (6th ed.). New York: Wiley and Sons. Froot, K.A., Scharfstein, D.S. and Stein, J.C. (1994). A framework for risk management. Harvard Business Review, November-December, p. 91-102. Harper, D. (2005) Corporate Use of Derivatives for Hedging. Investopedia. [online] Available from http://www.investopedia.com/article/ [Accessed 26 April 2006]. Hull, J. (2000). Options, Futures, and Other Derivatives, 4th ed. New York: Prentice Hall. Malkiel, B.G. (1999). A random walk down Wall Street. New York: W.W. Norton. Pike, R. and Neale, B. (2003). Corporate finance and investment: decisions and strategies (4th ed.). New York: Prentice Hall. Read, C. and Kaufman, S. (Eds.) (1997). CFO: Architect of the corporation's future, by the Price Waterhouse Financial & Cost Management Team. New York: Wiley & Sons. Sagan, J. (1955). Toward a theory of working capital management. Journal of Finance, 10 (2), p. 121-129. Shapiro, A. (2003). Multinational financial management (7th ed.). New York: Prentice Hall. Sharpe, W.F. (1991). The arithmetic of active management. Financial Analysts' Journal, 47 (1), p. 7-9. Sobel, R. (2000) The pursuit of wealth: The incredible story of money throughout the ages. New York: McGraw-Hill. Yardeni, E. E. (1978). A portfolio-balance model of corporate working capital. Journal of Finance, 33 (2), p. 535-552. Table 1. Table of Computations for Working Capital Management of Raphael Ltd Given Data: Notes Current working cap mgt system Desired terms, in days 30 Actual terms, in days 50 Annual credit sales, in GBP 2,400,000 Days per year 360 Daily credit sales equivalent 6,667 Total bad debts, in % 1.5% Overdraft rate, in % p.a. 12% Option A; Factoring Credit sales for Factoring 80% Interest rate on unpaid amount 11% Desired terms, in days 30 Annual process savings, in GBP 18,000 Process service charge, in % 2% of sales Option B: Credit Policies Discount within 30 days, in % 1% Projected availment rate, in % 40% Remaining trade debtors, in % 60% Overdraft rate, in % p.a. 12% Projected bad debts, in % 1% Drop by 0.5% p.a. Cost of current working capital mgt system: Delayed collections, days 50 unpaid daily sales Annual trade debt, in GBP 333,333 50 days of sales Interest on debt, in GBP 40,000 12% of trade debts Bad debts, in GBP 36,000 1.5% of sales Total cost p.a., in GBP 76,000 As percent of sales 3.2% Cost of Option A: Amount of factor advance, in GBP 1,920,000 Annual trade debt, in GBP 200,000 30 days of sales Interest charges on advance 22,000 at 11% from Factor Savings on collection (18,000) outsourced to Factor Savings on bad debts (36,000) Service charge 48,000 2% of sales Total cost p.a., in GBP 16,000 As percent of sales 0.7% Net cash inflow from Option A 60,000 Net of current system Cost of Option B: Credit sales availing of discount 960,000 40% of customers Credit sales not availing of discount 1,440,000 Cost of discount (9,600) 1% of credit sales Savings from collected credit sales 6,400 20 days of discounts Savings from bad debts 12,000 down by 0.5% p.a. Net cash inflow from Option B 8,800 Savings less discounts (Source: Case Study) Read More