Transcript SHORT-TERM FINANCIAL MANAGEMENT Chapter 7 – Managing Supplier Financing Chapter 7 Agenda MANAGING SUPPLIER FINANCING Apply time value of money principles to the payment of.

SHORT-TERM
FINANCIAL MANAGEMENT
Chapter 7 – Managing Supplier Financing
2
Chapter 7 Agenda
MANAGING SUPPLIER FINANCING
Apply time value of money principles to
the payment of accounts payable, decide
when the cash discount is optimal,
understand ethical issues involved in the
payment decision, and assess payables
using the balance fraction approach.
Cash Flow Timeline
3
The cash
conversion
period is the
time between
when cash is
received versus
paid.

The firm is a system of cash flows.

These cash flows are unsynchronized and uncertain.
The shorter the
cash conversion
period, the
more efficient
the firm’s
working capital.
Note: The clock typically starts ticking when the order is
received, not when the order is placed or the invoice received.
A/P Timing
4

In Chapter 4, we studied optimal inventory levels and
considered the impact on NPV from quantity and cash
discounts. In this chapter, we take it a step further and
decide when to pay A/P.
Managing Supplier Financing
5




Most firms buy inventory on credit, creating an
Accounts Payable.
The inventory is subsequently sold to customers on
credit, creating an Accounts Receivable.
In the meantime, the firm incurs expenses (e.g.: salaries,
wages, taxes) for which payment has not yet been
made, creating an Accrual.
A/P and Accruals are generally due before A/R are
received.
Managing Supplier Financing
6



A/P (also called Trade Credit) and Accruals represent
spontaneous sources of financing for a firm, allowing
the working capital cycle to continue without making
cash disbursements.
Trade credit is effectively a “free” source of financing.
Firms establish policies on how to manage these
accounts.
Types of Supplier Financing
7

There are several types of purchase terms:

Open Account



Net Terms vs. Discount Terms
Seasonal Dating



Once credit is approved, the firm may repeatedly submit orders
without reapplying for credit.
Used in seasonal businesses (e.g.: toys).
“2/10, net 30, dating 90” allows customers to take the 2% discount
within 10 days or pay the invoice in full within 30 days after the 90
day period ends (120 days from purchase date; same as “2/10, net
120”).
Consignment

Payment is made only if the item is sold (e.g.: textbook inventory in
college bookstores).
Supplier Financing
8


The concept of A/P is the same as A/R, but from the
opposite perspective.
Say, a firm receives an invoice from a supplier with
the terms 2/10, net 30.

The firm pays $98 per $100 invoiced amount if they pay
within 10 days.

Taking the discount requires the firm to part with cash 20
days sooner, but it may deduct 2% from the amount
owed.

Should the firm take the discount?
Modeling A/P Timing
9

We’ll look at two methods:
 NPV
 Annualized
Cash Discount Rate
A/P Payment Timing Options
10

Firm’s establish an A/P policy based on the number
of days payment is delayed from the purchase
date (DD), choosing from:
1.
Date of purchase.

2.
On or before end of cash discount period (DP).

3.
DD < DP
On or before end of credit period (CP).

4.
DD = 0
DD < CP
After credit period ends.

DD > CP
A/P Payment Timing Options
11



Say, the terms
offered are 2/10,
net 30:
Firms must determine
when to pay
invoices.
Like before, we
apply TVM
principles to the
payment timing of
A/P, seeking the
lowest NPV.
Purchase
DP
0 Days 10 Days
CP
30 Days
>CP
> 30 Days
1) (DD=0)
2) DD < DP
3) DD < CP
4) DD > CP
A/P Decision Models - NPV
12


Shown are the variables associated with this decision:
Deciding when to pay
considers these rates:
Variables
Terms
Invoice Price (IP )

Cash discount rate (d)

Annualized investment rate (i)
Days Until Payment is Made (DD)
Discount Period (DP )
Credit Period (CP )


Annualized borrowing rate (ib)
Annualized late payment rate
(fee)
Cash Discount Rate (d)
Annual Opportunity Cost (i)
Annual Borrowing Rate (i b )
Annual Fee / Intangible Cost of Late Payment (fee)
A/P Decision Models - NPV
13

There are three Decision
Models based on the
timing of the delayed
payment.
Variables
Terms
Invoice Price (IP )
Days Until Payment is Made (DD)


Discount Model

Credit Period Model

Late Payment Model
WE ARE DECIDING THE
OPTIMAL TIMING OF DD.
Discount Period (DP )
Credit Period (CP )
Cash Discount Rate (d)
Annual Opportunity Cost (i)
Annual Borrowing Rate (i b )
Annual Fee / Intangible Cost of Late Payment (fee)
Payment Decision Model #1
14

Discount Model - Payment made on or before the end of the
cash discount period (DD < DP):
Variables
Terms
Invoice Price (IP )
Days Until Payment is Made (DD)
Discount Period (DP )
PV of discounted invoice price
Credit Period (CP )
Cash Discount Rate (d)
Annual Opportunity Cost (i)
Annual Borrowing Rate (i b )
Annual Fee / Intangible Cost of Late Payment (fee)
Payment Decision Model #2
15

Credit Period Model - Payment made on or before the end of
the credit period (DD < CP):
Variables
Terms
Invoice Price (IP )
Days Until Payment is Made (DD)
Discount Period (DP )
PV of full invoice price
Credit Period (CP )
Cash Discount Rate (d)
Annual Opportunity Cost (i)
Annual Borrowing Rate (i b )
Annual Fee / Intangible Cost of Late Payment (fee)
Payment Decision Model #3
16

Late Payment Model - Payment made after the credit
period ends (DD > CP):
Variables
(IP) [1 +(DD-CP)(fee/365)]
NPV = - ---------------------------------[1 + (DD)(i/365)]
Terms
Invoice Price (IP )
Days Until Payment is Made (DD)
Discount Period (DP )
PV of full invoice price plus late fee
Credit Period (CP )
Cash Discount Rate (d)
Annual Opportunity Cost (i)
Annual Borrowing Rate (i b )
Annual Fee / Intangible Cost of Late Payment (fee)
Payment Decision Model Example
17

A firm receives an
$100,000 invoice
from a supplier with
the terms 2/5, net
45.

Should the firm:

Take the discount?

Pay within the credit
period?

Pay late?
Variables
Current Terms (E)
Terms
2/5, Net 45
Invoice Price (IP )
$100,000
Days Until Payment is Made (DD)
TBD
Discount Period (DP )
0-5 Days
Credit Period (CP )
6-45 Days
Cash Discount Rate (d)
2%
Annual Opportunity Cost (i)
10%
Annual Borrowing Rate (i b )
12%
Annual Fee / Intangible Cost of Late Payment (fee)
18%
Payment Decision Model Example
18

The invoice is $100,000 with
terms of 2/5, net 45:



Days Delayed From
Invoice Date
0
Discount Model - The check amount
for 0-5 days is $98,000…the NPV
decreases as time passes.
1
Credit Period Model - The check
amount for 6-45 days is
$100,000…the NPV decreases as
time passes.
5
Late Payment Model - The check
amount for >45 days is $100,000
plus the late fee…the NPV
increases as time passes.
2
3
$98,000 mailed
to supplier
4
6
15
20
25
30
$100,000 mailed
to supplier
35
40
45
46
47
48
$100,000 plus
time-based fee
mailed to supplier
Payment Decision Model Example
19

The invoice is
$100,000
with terms of
2/5, net 45.

i = 10%
Days Delayed From
Invoice Date
NPV (10%
Investment Rate)
0
$98,000
1
$97,973
2
$97,946
3
$97,920
4
$97,893
5
$97,866
6
$99,836
15
$99,591
20
$99,455
25
$99,320
30
$99,185
35
$99,050
40
$98,916
45
$98,782
46
$98,804
47
$98,826
48
$98,848
Discount Model
[(IP)(1-d)] / [1 + (DD)(i/365)]
[$100,000(1-.02)] / [1+(5)(.10/365)]
= $97,866
Payment Decision Model Example
20

The invoice is
$100,000
with terms of
2/5, net 45.
Days Delayed From
Invoice Date
NPV (10%
Investment Rate)
0
$98,000
1
$97,973
2
$97,946
3
$97,920
4
$97,893
5
$97,866
6
$99,836
Credit Period Model
15
$99,591
IP / [1 + (DD)(i/365)]
20
$99,455
25
$99,320
30
$99,185
35
$99,050
40
$98,916
45
$98,782
46
$98,804
47
$98,826
48
$98,848
$100,000 / [1+(45)(.10/365)]
= $98,782
Payment Decision Model Example
21

The invoice is
$100,000
with terms of
2/5, net 45.
Days Delayed From
Invoice Date
NPV (10%
Investment Rate)
0
$98,000
1
$97,973
2
$97,946
3
$97,920
4
$97,893
5
$97,866
6
$99,836
15
$99,591
20
$99,455
25
$99,320
30
$99,185
35
$99,050
40
$98,916
45
$98,782
46
$98,804
47
$98,826
48
$98,848
Late Payment Model
(IP) [1 +(DD-CP)(fee/365)] /
[1 + (DD)(i/365)]
($100,000)[1+(48-45)(.18/365)] /
[1+(48)(.10/365)] = $98,848
Payment Decision Model Example
22

The invoice is
$100,000 with
terms of 2/5,
net 45:

Paying on the
fifth day and
taking the
discount
provides the
lowest NPV.
Days Delayed From
Invoice Date
NPV (10%
Investment Rate)
0
$98,000
1
$97,973
2
$97,946
3
$97,920
4
$97,893
Credit Period Model
5
$97,866
IP / [1 + (DD)(i/365)]
6
$99,836
15
$99,591
20
$99,455
25
$99,320
30
$99,185
35
$99,050
40
$98,916
45
$98,782
46
$98,804
47
$98,826
48
$98,848
Discount Model
[(IP)(1-d)] / [1 + (DD)(i/365)]
[$100,000(1-.02)] / [1+(5)(.10/365)]
= $97,866
$100,000 / [1+(45)(.10/365)]
= $98,782
Late Payment Model
(IP) [1 +(DD-CP)(fee/365)] /
[1 + (DD)(i/365)]
($100,000)[1+(48-45)(.18/365)] /
[1+(48)(.10/365)] = $98,848
Payment Decision Model Example
23
Days Delayed From
Invoice Date
NPV (10%
Investment Rate)
NPV (20%
Investment Rate)
0
$98,000
$98,000
1
$97,973
$97,946
2
$97,946
$97,893
3
$97,920
$97,839
4
$97,893
$97,786
5
$97,866
$97,732
6
$99,836
$99,672
Current Terms (E)
15
$99,591
$99,185
Terms
2/5, Net 45
20
$99,455
$98,916
Invoice Price (IP )
$100,000
25
$99,320
$98,649
TBD
30
$99,185
$98,383
Discount Period (DP )
0-5 Days
35
$99,050
$98,118
Credit Period (CP )
6-45 Days
40
$98,916
$97,855
Cash Discount Rate (d)
2%
45
$98,782
$97,594
Annual Opportunity Cost (i)
20%
46
$98,804
$97,590
Annual Borrowing Rate (i b )
12%
47
$98,826
$97,585
Annual Fee / Intangible Cost of Late Payment (fee)
18%
48
$98,848
$97,581

What if the
investment rate (i) is
20%.

Paying late now has
the lowest NPV.
Variables
Days Until Payment is Made (DD)
Discount Model
Credit Period
Model
Late Payment
Model
Payment Decision Model - NPV
24


While we calculated many possible dates before, only
three need to be calculated:

Last day of discount period.

Last day of credit period.

Some late date after credit period ends.
In general:

A/P should never be paid early.


Pay on the last day of the discount period or the last day of the
credit period.
A/P should not be stretched past the credit period.
Paying Late
25

If the late payment penalty fee (fee) is less than the
firm's investment rate (i), the firm has a financial
incentive to pay late.
 There
are consequences to the firm’s brand for paying
late:
 New
 The
orders will not be shipped until the account is current.
firm’s reputation and credit rating can be comprised.
Payment Decision Model - NPV
26


Since late payments should be avoided, it is the one of the first
two models (Discount or Credit Period) with the lower NPV that
is selected.
Choose the smaller of:
 [(IP)(1-d)]
/ [1 + (DD)(i/365)]
 IP / [1 + (DD)(i/365)]
Alternative Decision Model
27

The reason we would forego the
discount is to retain the funds to finance
operations or to invest short-term.
Variables
Terms


The cash discount is not an interest
rate; rather, it is a discount off the
amount of the invoice.
It can be converted to an interest rate,
and then be compared to i and ib.
Invoice Price (IP )
Days Until Payment is Made (DD)
Discount Period (DP )
Credit Period (CP )
Cash Discount Rate (d)
Annual Opportunity Cost (i)
Annual Borrowing Rate (i b )
Annual Fee / Intangible Cost of Late Payment (fee)

So, an alternative approach to
calculating NPV is to compare the
Annualized Cash Discount Rate (d).
Alternative Decision Model
28



For terms, 2/5, net 45, if we forego the
discount, we pay 2% more for the product.
Said another way, we are paying 2% more
to simply keep our cash for an extra 40
days.
We can convert that to the annualized
equivalent:
k TC
 d
 
 (1- d
 365 


)  (CP  DP) 
Variables
Terms
Invoice Price (IP )
Days Until Payment is Made (DD)
Discount Period (DP )
Credit Period (CP )
Cash Discount Rate (d)
Annual Opportunity Cost (i)
Annual Borrowing Rate (i b )
Annual Fee / Intangible Cost of Late Payment (fee)

If the i < kTC, the firm is
better off taking the
discount.

If the i > kTC, the firm
should keep the cash and
forego the discount.
Annualized Cash Discount Rate
[The first expression is the effective discount rate (the
discount divided by the discounted invoice) and the
second expressions annualizes the rate (the number of
times the rate would be realized in a year).]
Alternative Decision Model
29

Assuming the firm does not have the cash, but has access to
short-term credit, borrowing the money to take the discount
might make sense if the annualized borrowing rate (ib) is less
than annualized cash discount rate (kTC), given by:
 ib
< = > kTC = [d / (1 – d)] [365 / (CP-DP)]

If the ib < kTC, the firm should borrow to take the discount.

If the ib > kTC, the firm should forego the discount.
Alternative Decision Example
30

For our decision, the annualized cash
discount rate (kTC) is:

[d / ( 1 – d)] [365/(CP-DP)]




In our original analysis, with an i of 10%,
the discount rate is the more favorable
choice since 10% < 18.62%.
If i = 20%
Here, i > kTC > ib.


[.02/(1-.02)] [365/(45-5)] = 18.62%
20% > 18.62%, so forego discount.
However, since the firm has access to ST
credit at 12%, borrowing to take the
discount would make sense since kTC> ib.
Variables
Current Terms (E)
Terms
2/5, Net 45
Invoice Price (IP )
$100,000
Days Until Payment is Made (DD)
TBD
Discount Period (DP )
5 Days
Credit Period (CP )
45 Days
Cash Discount Rate (d)
2%
Annual Opportunity Cost (i)
10%
Annual Borrowing Rate (i b )
12%
Annual Fee / Intangible Cost of Late Payment (fee)
18%
i > kTC > ib
20% > 18.62% > 12%
Taking The Cash Discount
31


It almost always make sense to take the discount since the
cost is high for not taking the discount.
Research shows that:
 51%
of firms always take the discount.
 40%
sometimes take the discount.
 9%
take the discount regardless of when they pay!
Managing Payables
32

Credit Managers watch trends for:
 Payables
 Days
Turnover Ratio
Payables Outstanding (DPO)
 Balance
Fraction Approach
 Compares
month.
ratio of purchases to payables outstanding by
Accruals
33


Accruals represent an operating expense that has
contributed to firm productivity but for which the expense
has not been paid.
A firm has minimal latitude in the timing of paying Accruals.

e.g.: Lengthening accrued wages means delaying payment to
your workers.
34