Foundations of Financial Management: An Analysis (part 16)

“You cannot escape the responsibility of tomorrow by evading it today.”

~Abraham Lincoln~

Working Capital and the Financing Decision

(part B)

by

Charles Lamson

Controlling Assets---Matching Sales and Production

In most firms fixed assets grow slowly as productive capacity is increased and old equipment is replaced, but current assets fluctuate in the short run, depending on the level of production versus the level of sales. When the firm produces more than it sells, inventory rises. When sales rise faster than production, inventory declines and receivables rise.

Some firms employ level production (producing at a constant rate regardless of the demand level) methods to smooth production schedules and use manpower and equipment efficiently at a lower cost. One consequence of level production is that current assets go up and down when sales and production are not equal. Other firms may try to match sales and production as closely as possible in the short run. This allows current assets to increase or decrease with the level of sales and eliminates the large seasonal bulges or sharp reductions in current assets that occur under level production.

Publishing companies are good examples of companies with seasonal sales and inventory problems. By the nature of the textbook market, heavy sales are made in the third quarter of each year for fall semester sales. Most sales occur in July, August, September, and again in December for the second semester. The actual printing and binding of a book have fixed costs that make printing many copies more efficient. Since publishing companies reproduce books on demand, they contract with the printing company to print a fixed number of copies, depending on expected sales over at least one year and sometimes based on sales over several years. If the books sell better than expected, the publishing company will order a second or third printing. Orders may have to be placed as much as nine months before the books will actually be needed, And reorders will be placed as much as three or four months ahead of actual sales. If the book declines in popularity, the publisher could get stuck with a large inventory of obsolete books.

As mentioned above, most textbooks are sold to bookstores in August, September, and December. The smallest sales are in the first quarter and second quarters of the year and the heavy fixed costs of publishing cause very low earnings per share in these two quarters.

Because of the seasonal nature of the textbook publishing business, lenders as well as financial managers need to understand the need for inventory financing and inventory management. If management has not planned inventory correctly, lost sales due to stock outs could be a serious problem.

Retail firms, also have seasonal sales patterns. These companies do not stock a year or more of inventory at one time as do publishers. They are selling products that are either manufactured for them by others or manufactured by their subsidiaries. Most retail stores are not involved in deciding on level versus seasonal production but rather in matching sales and inventory. Their suppliers must make the decision to produce on either a level or a seasonal basis. Since the selling seasons are very much affected by the weather and holiday periods, the suppliers and retailers cannot avoid the inventory risk. The fourth quarter for retailers which begins in November and ends in January, is the biggest quarter and accounts for as much as one half of their earnings. You can be sure that inventory not sold during the Christmas season will be put on sale during January.

We shall see as we go through the next couple of posts that seasonal sales can cause asset management problems. A financial manager must be aware of these problems to avoid getting caught short of cash or unprepared to borrow when necessary.

Many retail-oriented firms have been more successful in matching sales and orders in recent years because of new, computerized inventory control systems linked to online point-of-sales terminals. These point-of-sale terminals allow either digital input or use of optical scanners to record the inventory code numbers and the amount of each item sold. At the end of the day, managers can examine sales and inventory levels item-by-item and, if need be, adjust orders or production schedules. The predictability of the market will influence the speed with which the manager reacts to this information, while the length and complexity of the production process will dictate just how fast production levels can be changed. 

Temporary Assets under Level Production---An Example

To get a better understanding of how current assets fluctuate, let us use the example of the Yawakuzi Motorcycle Company, which manufactures and sells in the snowy U.S. Midwest. Not too many people will be buying motorcycles during October through March, but sales will pick up in early spring and summer and will again trail off during the fall. Because of the fixed assets and the skilled labor involved in the production process, Yawakuzi decides that level production is the least expensive and the most efficient production method. The marketing department provides a 12-month sales forecast for October through September (Table 1).

Table 1 Yawakuzi sales forecast (in units)

After reviewing the sales forecast, Yawakuzi decides to produce 800 motorcycles per month, or one year's production of 9,600 divided by 12. A look at Table 2 shows how level production and seasonal sales combine to create fluctuating inventory. Assume that October's beginning inventory is one month's production of 800 units. The ending inventory level is computed for each month and then multiplied by the production cost per unit of $2,000.

Table 2 Yawakuzi's Production Schedule and Inventory

The inventory level at cost fluctuates from a high of $9 million dollars in March, the last consecutive month in which production is greater than sales, to a low of $1 million in August, the last month in which sales are greater than production. Table 3 combines sales forecast, a cash receipts schedule, a cash payment schedule, and a brief cash budget in order to examine the build-up and accounts receivable and cash.

Table 3 Sales forecast, cash receipts and payments, and cash budget

In Table 3 the sales forecast is based on assumptions in Table 1. The unit volume of sales is multiplied by a sales price of $3,000 to get sales dollars in millions. Next, cash receipts represent 50 percent collected in cash during the month of sale and 50 percent from the prior month's sales. For example, in October this would represent point 45 million dollars from the current month plus 75 million dollars from the prior month's sales.

Cash payments in Table 3 are based on an assumption of level production of 800 units per month at a cost of $2,000 per unit, or 1.6 million dollars, plus payments for overhead, dividends, interest, and taxes.

Finally, the cash budget in Table 3 represents a comparison of the cash receipts and cash payments schedules to determine cash flow. We further assume the firm desires a minimum cash balance of 25 million dollars plus in October, a negative cash flow of $1.1 million brings the cumulative cash balance to a negative $0.85 million and $1.1 million must be borrowed to provide an ending cash balance of $0.25 million. Similar negative cash flows in subsequent months necessitate expanding the bank loan. For example, in November there is a negative cash flow of $1.325 million. This brings the cumulative cash balance to -$1.075 million, requiring additional borrowings of $1.325 million to ensure a minimum cash balance of $0.25 million. The cumulative loan through November, October, and November borrowings now adds up to $2.425 million. Our cumulative bank loan is highest in the month of March.

We now wish to ascertain our total current asset build-up as a result of level production and fluctuating sales for October through September. The analysis is presented in Table 4. The cash figures come directly from the last line of table 3. The accounts receivable balance is based on the assumption that accounts receivable represent 50 percent of sales in a given month, as the other percent is paid for in cash. Thus the accounts receivable figure in Table 4 represents 50 percent of the sales figure from the second numerical line in Table 3. Finally, the inventory figure in Table 4 is taken directly from the last column of Table 2, which presented the production schedule and inventory data.

Table 4 Total current assets, first year ($ millions)

Total current assets (last column in Table 4) start at $3.3 million in October and rise to $10.35 million in the peak month of April. From April through August, sales are larger than production, and inventory falls to its low of $1 million in August, but accounts receivable peak at $3 million in the highest sales months of May, June, and July. The cash budget in Table 3 explains the cash flows and external funds borrowed to finance asset accumulation. From October to March, Yawakuzi borrows more and more money to finance the inventory build-up, but from April forward it eliminates all borrowing as inventory is liquidated and cash balances rise to complete the cycle. In October the cycle starts over again; but now the firm has accumulated cash it can use to finance next year's asset accumulation, pay a larger dividend, replace old equipment, or if growth in sales is anticipated invest in new equipment to increase productive capacity. Table 5 represents the cash budget and total current assets for the second year. Under a simplified no growth assumption, the monthly cash flow is the same as that of the first year, but beginning cash in October is much higher from the first year's ending cash balance and this lowers the borrowing requirement and increases the ending cash balance and total current assets at year-end. Higher current assets are present despite the fact that accounts receivable and inventory do not change.

Table 5 Cash budget and assets for second year with no growth in sales ($millions)

Figure 1 is a graphic presentation of the current asset cycle. It includes the two years covered in Tables 4 and 5 assuming level production and no sales growth. 

Figure 1     

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, PP. 146-153*

end

Did the Toltecs Stumble Upon Mesoamerica's Origins?

Foundations of Financial Management: An Analysis (part 15)

“The most difficult thing is the decision to act, the rest is merely tenacity.”

~Amelia Earhart~

 Working Capital and the Financing Decision

by

 Charles Lamson

The rapid growth of business firms in the last several decades has challenged the ingenuity of financial managers to provide adequate financing. Rapidly expanding sales may cause intense pressure for inventory and receivables build up draining the cash resources of the firm. As indicated in the previous posts dealing with financial forecasting, a large sales increase creates an expansion of current assets, especially accounts receivable and inventory. Some of the increased current assets can be financed through the firm's retained earnings, but in most cases internal funds will not provide enough financing and some external sources of funds must be found. In fact, the faster the growth and sales, the more likely it is that an increasing percentage of financing will be external to the firm. These funds could come from the sale of common stock, preferred stock, long-term bonds, short-term securities, and bank loans, or from a combination of short and long-term sources of funds.

There is also the problem of seasonal sales that affect many industries such as soft drinks, toys, retail department stores, and text book publishing companies. Seasonal demand for products makes forecasting cash flows and receivables and inventory management difficult. The Internet is alleviating some of these problems and helping management make better plans.

If your familiar at all with marketing, you have heard about supply chain management. Well, financial executives are also interested in the supply chain as an area where the Internet can help control work working capital through online software. McDonald's Corporation of Big Mac fame formed eMac Digital to explore opportunities in business-to-business (B2B) online ventures (Block & Hirt, 2005, p. 144). McDonald's wanted to create an online marketplace where restaurants can buy supplies online from food companies. McDonald's, like Walmart, Harley-Davidson, and Erickson has embraced supply chain management using web-based procedures. The goal is to squeeze out inefficiencies in the supply chain and thereby lower costs. One of the big benefits is a reduction in inventory through online communications between the buyer and supplier, which speeds up the ordering and delivery process and reduces the amount of inventory needed on hand. These systems may also be able to attract a large number of suppliers to bid on the company's business at more competitive prices.

Working capital management involves the financing and management of the current assets of the firm. The financial executive probably devotes more time to working capital management than to any other activity. Current assets, by their very nature, are changing daily, if not hourly, and managerial decisions must be made. "How much inventory is to be carried, and how do we get the funds to pay for it?" Unlike long-term decisions, there can be no deferral of action. While long-term decisions involving plant and equipment or market strategy may well determine the eventual success of the firm, short-term decisions on working capital determine whether the firm gets to the long-term.

In the next few posts, we examine the nature of asset growth, the process of matching sales and production, financial aspects of working capital management, and the factors that go into development of an optimum policy.

The Nature of Asset Growth

Any company that produces and sells a product, whether the product is consumer or manufacturer oriented, will have current assets and fixed assets. If a firm grows, those assets are likely to increase over time. The key to current asset planning is the ability of management to forecast sales accurately and then to match the production schedules with the sales forecast. Whenever actual sales are different from forecasted sales, unexpected buildups or reductions in inventory will occur that will eventually affect receivables and cash flow. 

In the simplest case, all of the firm's current assets will be self liquidating assets sold at the end of a specified time period. Assume that at the start of the summer you buy 100 tires to be disposed of by September. It is your intention that all tires will be sold, receivables collected, and bills paid over this time period. In this case your working capital current asset needs are truly short-term.

Now let us begin to expand the business. In stage two you add ratios, seat covers, and batteries to your operation. Some of your inventory will again be completely liquidated, while other items will form the basic stock for your operation. Furthermore, not all items will sell. As you eventually grow to more than one store, this permanent aggregate stock of current assets will continue to increase. Problems of inadequate financing arrangements are often the result of the businessperson's failure to realize the firm is carrying not only self-liquidating inventory, but also the anomaly of permanent current assets.

The movement from stage 1 to Stage 2 of growth for a typical business is depicted in Figure 1. In Panel A the buildup in current assets is temporary---while in Panel B, part of the growth and current assets is temporary and part is permanent. Fixed assets are included in the illustrations, but they are not directly related to the present discussion. 

Figure 1

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, PP. 144-146*

end

Foundations of Financial Management: An Analysis (part 14)

“The desire of gold is not for gold. It is for the means of freedom and benefit.”

~Ralph Waldo Emerson~

Operating and Financial Leverage

(part C)

by

Charles Lamson

Combining Operating and Financial Leverage

If both operating and financial leverage allow us to magnify our returns, then we will get maximum leverage through their combined use in the form of combined leverage. We have said that operating leverage affects primarily the asset structure of the firm, while financial leverage affect the debt-equity mix. From an income statement viewpoint, operating leverage determines return from operations, while financial leverage determines how the "fruits of our labor" will be allocated to debt holders and, more importantly, to stockholders in the form of earnings per share. Table 6 shows the combined influence of operating and financial leverage on the income statement. The values in Table 6 are drawn from Tables 2 and 5 presented in preceding posts. We assumed in both cases a high degree of operating and financial leverage (i.e., the leveraged firm). The sales volume is 80,000 units.

Table 5 Income statement

You will observe, first, that operating leverage influences the top half of the income statement determining operating income. The last item under operating leverage, operating income, then becomes the initial item for determining financial leverage. "Operating income" and "Earnings before interest and taxes" are one in the same, representing the return to the corporation after production, marketing, and so forth---but before interest and taxes are paid. In the second half of the income statement, we then show the extent to which earnings before interest and taxes are translated into earnings per share. A graphical representation of these points is provided in Figure 5. 

Figure 5

Degree of Combined Leverage

Degree of combined leverage (DCL) uses the entire income statement and shows the impact of a change in sales or volume on bottom-line earnings per share. Degree of operating leverage and degree of financial leverage are, in effect, being combined. Table 7 shows what happens to profitability as the firm's sales go from $160,000 (80,000 units) to $200,000 (100,000 units).

Table 7

The formula for degree of combined leverage is stated as:

Using data from table 7:

Every percentage point change in sales will be reflected in a 4 percent change in earnings per share at this level of operation (quite an impact).

An algebraic statement of the formula is:

From Table 7: Q (Quantity) = 80,000; P (Price per unit) = $2.00; VC (Variable costs per unit) = $0.80; FC (Fixed costs) = $60,000; and I (Interest) = $12,000.

The answer is once again is shown to be 4.

A Word of Caution

In a sense, we are piling risk on risk as the two different forms of leverage are combined. Perhaps a firm carrying heavy operating leverage may wish to moderate its position financially, and vice versa. One thing is certain---the decision will have a major impact on the operations of the firm.

Summary

Leverage may be defined as the use of fixed cost items to magnify returns at high levels of operation. Operating leverage primarily affects fixed versus variable cost utilization in the operation of the firm. An important concept---degree of operating leverage (DOL)---measures the percentage change in operating income as a result of a percentage change in volume. The heavier the utilization of fixed-cost assets, the higher DOL is likely to be.

Financial leverage reflects the extent to which debt is used in the capital structure of the firm. Substantial use of debt will place a great burden on the firm at low levels of profitability. But it will help to magnify earnings per share as volume or operating income increases. We combine operating and financial leverage to assess the impact of all types of fixed costs on the firm. There is a multiplier effect when we use the two different types of Leverage.

Because leverage is a two-edged sword, management must be sure the level of risk assumed is in accord with its desire for risk and its perceptions of the future. High operating leverage may be balanced off against lower financial leverage if this is deemed desirable, and vice versa. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 125-129*

end

Foundations of Financial Management: An Analysis (part 13)

A man who pays his bills on time is soon forgotten.

Oscar Wilde

Operating and Financial Leverage (part B)

by

Charles Lamson

Financial Leverage

Having discussed the effects of fixed costs on the operations of the firm (operating leverage from last post), we now turn to the second form of leverage. Financial leverage reflects the amount of debt used in the capital structure of the firm. Because that carries a fixed obligation of interest payments, we have the opportunity to greatly magnify our results at various levels of operations. You may have heard of the real estate developer who borrows 100 percent of the costs of his project and will enjoy an infinite return on his zero investment if all goes well.

It is helpful to think of operating leverage as primarily affecting the left-hand side of the balance sheet and financial leverage as affecting the right-hand side. 

Whereas operating leverage influences the mix of plant and equipment, financial leverage determines how the operation is to be financed. It is possible for two firms to have equal operating capabilities and yet show widely different results because of the use of financial leverage.

Impact on Earnings

In studying the impact of financial leverage, we shall examine two financial plans for a firm, each employing a significantly different amount of debt in the capital structure. Financing totaling $200,000 is required to carry the assets of the firm. The facts are presented below.

Under leveraged Plan A we will borrow $150,000 and sell 8,000 shares of stock at $6.25 to raise an additional $50,000, whereas conservative Plan B calls for borrowing only a $50,000 and acquiring an additional $150,000 in stock with 24,000 shares.

In Table 5, we compute earnings per share for the two plans at various levels of "earnings before interest and taxes" (EBIT). These earnings (EBIT) represent the operating income of the firm before deductions have been made for financial charges or taxes. we assume (EBIT) levels of 0, $12,000, $16,000, $36,000, and $60,000. 

Table 5 Impact of financing plan on earnings per share

The impact of the two financing plans is dramatic. Although both plans assume the same operating income, or EBIT, for comparative purposes at each level say ($36,000 in calculation 4) the reported income per share is vastly different ($1.50 versus $0.67). it is also evident the conservative plan will produce better results at low income levels but the leverage plan will generate much better earnings per share as operating income, or EBIT, goes up. The firm would be indifferent between the two plans at an EBIT level of $16,000 as shown in Table 5.

In figure 4 on page 124, we graphically demonstrate the effect of the two financing plans on earnings per share and the indifference point at an Abbot of 16 $1,000. With an Abbot of $16,000, we are earning 8% on total assets of $200,000 precisely the percentage cost of borrowed funds to the fern. The use or non-use of debt does not influence the answer. Beyond $16,000, plan a, employing heavy financial leverage, really goes to work, allowing the firm to greatly expand earnings per share as a result of a change in ebit. For example, at the ebit level of 36000, and 18% return on assets of $200,000 takes place and a financial leverage is clearly working to our benefit as earnings greatly expand.

Figure 4

Degree of Financial Leverage

As was true of operating leverage, degree of financial leverage measures the effect of a change in one variable on another variable. Degree of financial leverage (DFL) may be defined as the percentage change in earnings (EPS) that occurs as a result of a percentage change in earnings before interest and taxes (EBIT).

Formula 4

For purposes of computation, the formula for DFL may be conveniently restated as:

Formula 5

Let's compute the degrees of financial leverage for Plan A and plan B, previously presented in Table 5, at an EBIT level of $36,000. Plan A calls for $12,000 of interest at all levels of financing, and plan B requires $4,000.

Plan A (Leveraged)

Plan B (Conservative)

As expected, Plan A has a much higher degree of financial leverage. At an EBIT level of $36,000, a 1 percent increase in earnings will produce a 1.5 earnings increase in earnings per share under Plan A, but only a 1.1 percent increase under Plan B. DFL may be computed for any level of operation, and it will change from point to point, but Plan A will always exceed Plan B.

Limitations to Use of Financial Leverage

The alert readers of this blog may quickly observe that if debt is such a good thing, why sell any stock? With exclusive debt financing at an EBIT level of $36,000 we would have a degree of financial leverage factor DFL of 1.8.

(With no stock, we would borrow the full $200,000.)

As stressed throughout this analysis, debt financing and financial leverage offer unique advantages, but only up to a point---beyond that point, debt financing may be detrimental to the firm. For example, as we expand the use of debt in our capital structure, lenders will perceive a greater financial risk for the firm. For that reason, they may raise the average interest rate to be paid and they may demand that certain restrictions be placed on the corporation. Furthermore, concerned common stockholders may drive down the price of the stock---forcing us away from the objective of maximizing the firm's overall value in the market. The impact of financial leverage must be carefully weighed by firms with high debt.

This is not to say that financial leverage does not work to the benefit of the firm---it does if properly used. Further discussion of appropriate debt-equity mixes is covered in later posts. For now, we accept the virtues of financial leverage, knowing that all good things must be used in moderation. For firms that are in industries that offer some degree of stability, are in a positive stage of growth, and are operating in favorable economic conditions, the use of debt is recommended. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 121-125*

end

THIRD EYE CHAKRA HEALING Hang Drum Music || Overcome Indecisiveness || F...