Operating Leverage
DOL = Changes in EBIT / Changes In Sales Or Contribution Margin / EBIT
Higher DOL-means profitance :sensitive to change in sales
-high fixed cost
- more risks
Example:
Sales= 100,000
VC= 60,000
FC=20,000
CM= 100,000- 60,000=40,000
EBIT= 40,000-20,000=20,000
DOL = 40,000 / 20,000 = 2.0
High DOL = high risk, more reward
Low DOL= low risk, small potential for growth
High Fixed cost = must know how to balance, in order to balance FC and VC
Financial Leverage
● Relying on debt to operate the business rather than equity- trade off of liability and equity.
● Advantage is higher returns to shareholders
Example: M2_Assignment 2
Problem 1-Parker Company
DOL= 400,000-125,000
= 275,000 - 200,000
= 75,000 / 275,000
= 3.7
Working Capital Management
Consideration of the two = Current Assets - Current Liabilities
… preferably higher current asset= liquidity
Deficit if higher liability
Working Capital
Current Assets= to be realized in cash or to be consumed during the normal operating cycle or within 1 year whichever is
longer
Example: cash, accounts receivable, marketable securities, inventory, supplies, prepaid assets
Current Liabilities= liquidation or payment to the use of assets within the operating cycle or within one year, whichever is
longer
Example: accounts payable, notes payable, accrual- as long as within one year whichever is longer
Working Capital management- administration and control of the company’s working capital or how you manage working capital
primary objectives: to achieve the balance bet. return and risk
Working capital financial policies:
1. Conservative or relax policy- too much of working capital, involves almost all our assets and investment
2. Regressive or restricted policy- operations are conducted on a minimum amount of working capital- so we uses the short
term liabilities to finance
3. Matching or self liquidation policy- matching the maturity of financing source with the specific needs
4. Balance policy- balance the trade off bet. Risk and profitability
Management of current asset
Consideration- operating cycle, means that it is the normal cycle of the company
(CASH-INVENTORY-SALES-A/R-CASH)
Formula of operating cycle…Inventory Conversion Period + A/R Conversion Period
ICP FORMULA
Inventory Turnover=COGS/Ave. Inventory
ICP=360 or 365 days/ Inventory Turnover
Or
Ave. Inventory/ Ave. COGS per day
ACP FORMULA
A/R Turnover= Net credit sales/ Ave. A/R
ACP= 360 or 365 days/ A/R Turnover
Or
Ave. A/R / Ave. Sale per day
Cash Conversion Period Formula
Short= Ave. Inventory/ Ave. COGS per day + Ave. A/R / Ave. Sale per day
- Ave. A/P / Ave. Purchase per day
Long= Inventory conversion period + A/R Conversion period - A/P Deferral
Inventory Turnover=COGS/Ave. Inventory
ICP=360 or 365 days/ Inventory Turnover
A/R Turnover= Net credit sales/ Ave. A/R
ACP= 360 or 365 days/ A/R Turnover
A/P Turnover= Net Purchases/ Ave. A/P
A/P Deferral = 360 or 365 days/ A/P Turnover
OR
Ave. A/P / Ave. Purchase per day
Cash Management - Involves the maintenance of the appropriate level of cash and investment in marketable securities - goal is to
maximize income and to generate funds
OBJECTIVES : To invest excess cash for a return while retaining sufficient liquidity.
Reasons Why Holding Cash:
1. To have a transaction purpose which is the day to day operations.
2. Compensating balance - which is a certain amount of cash that should be maintained in the bank
3. Precautionary reserves - handle unexpected problems
4. Potential Investment Opportunities - enough money to have investment potential
5. Speculations- delay purchases and store up cash for use to take advantage for possible changes in price of inventory
Cash management- float (difference between the bank balances for a firm account and the balance that the firm shows in its own
stocks) or in other words their would be a delay
Negative Float- Book balance exceed bank balance, because of :
a. mail float -peso amount of customer’s payment that was mailed by customer’s but not yet receive
b. processing Float- peso amount of customer payment received but not yet deposited
c. Clearing float- one day
Positive Float- bank balance is higher than book balance
a. Outstanding checks
Cash management strategies:
1. Accelerate cash collections
a. Bill customer prompt
b. Offer discounts for prompt payment
c. Use of lockbox system- Customers mails their payment to post office box to the specific city, local banks collect
the checks from this box and deposit to fimr account
=Goal is to reduce float or to be able to collect
2. Control or slowdown disbursement- as much as possible the firm pay through credit terms (maximize the firm credit terms)
3. Reduce the need for precautionary cash balance - lessen emergency cash balance
Cash break even point
BEP- TFC/ CM per Unit
BEP= TFC/CM %
Cash BEP= TFC - Non-Cash transaction/ CM per unit
Cash BEP= TFC - Non-cash transaction / CM %
Non-cash Transactions: No cash involve
Depreciation
Amortization of intangible assets
Cash management = BAUMOL MODEL -compute for the optimal cash balance
optimal cash balance
FORMULA:
Square root of 2(T)(D) / I
2 is constant
T is transaction cost which is the amount per transactions
I is the interest rate on the borrowing
D is the total demand for cash on time
Marketable securities management - liquid and short term money market instrument and easily converted to cash (example, gov.
Securities (like treasury bill, cert of time deposit, bank certificates) and commercial paper
Reasons of Holding Marketable Securities:
1. MS serve as substitute for cash
2. MS serve as temporary investment - interest is the goal
3. Cash is to be invested on MS to pay financial obligations
Consideration
-RISK of MS: Default Risk- Interest Rate- Inflation Risk
-Marketability
-Term to maturity
A/R Management - goal is the collection
-Optimal amount of receivables outstanding (low bad debts)
Factors:
1. Credit standard (4Cs : Character, Capacity, Conditions, Capital)
2. Credit Terms
Ways of Accelerating Collections of Receivable:
1. Shorten Credit Terms
2. Offer Special Discounts To Customers
3. Speed up Mailing Time of Payment
4. Minimize The Firm’s Float
Inventory Management
GOAL: Inventory - Sales (Formulations and Administration of plans )
Objective is to maintain inventory level and least cost as much as possible
Techniques:
1. Inventory planning
a. EOQ model
b. Reorder Point
c. Just in Time
2. Inventory Control
3. Modern Inv. Management
a. Material Requirement Planning
b. Manufacturing Resources Planning
c. Enterprise Resources Planning
Economic Order Quantity = Square Root of 2 (D) (OC) / CC
2- constant
D- demand Of inventory
OC- orderly cost
CC- carrying cost
High inventory =Low ordering cost = High Carrying Cost = vary inversely
Low Inventory = High ordering cost = Low carrying cost = vary directly
Working Capital Management
Problem #1
In its 2017 annual report, Luzvimin Corporation reported that it had revenues of P18 billion, cost of goods sold of
P16.8 billion, accounts receivable of P2.4 billion, inventory of P2.1 billion and accounts payable of P11.25 billion. (Use 360
working days) If silent, use 365 days.
Determine the cash conversion cycle.
Cash Conversion Cycle = Average Selling Period + Average Collection Period - Average Payment Period
Average Selling Period = 360 / (COGS/Inventory =360 / (P16.8 B / P2.1B) =45 Days
Average Collection Period = 360 / (revenue/A/R) =360 / (P18B / P2.4B) =48 Days
Average Payment Period = 360 / (A/P /1.25) = 360 / (P11.25B / 1.25B) =40 Days
CCC = 45 + 48 - 40 = 53 Days
Problem #2
The balance sheet of Olive Industries for December 31, 2016 contains the following. The amounts also pertain to the
average for the year. Use 360 working days.
ASSETS LIABILITIES AND SHAREHOLDERS EQUITY
Cash 10,000 Accounts Payable 56,250
Marketable Securities 80,000 Notes Payable (Short Term) 17,000
Accounts Receivable 60,000 Other Current Liabilities 52,000
Inventories 100,000 Long Term Debt 82,000
Plant and Equipment 220,000 Preferred Stocks 50,000
Less: Depreciation 64,000 Common Stocks 49,000
Net Plant and Equipment 156,000 Paid in Surplus 39,750
Retained Earnings 60,000
Total Assets 406,000
Total L & SE 406,00
Sales for the year amounted to P720,000. Mark up on cost is 60%.
1. What is the working capital? WC = CA CL
Cash P10,000
Marketable Securities 80,000
Accounts Receivable 60,000
Inventories 100,000
Less: Accounts Payable (56,250)
Notes Payable (Short Term) (17,000)
Other Current Liabilities (52,000)
Total P124,750
2. Determine the cash conversion cycle.
CCC = ASP + ACP - APP
Inventory Turnover = COGS /Average Inventory
(P720,000 / 160%) / P100,000
=4.5
ASP = 360 / Inventory Turnover
360 / 4.5 = 80 days
Accounts Receivable Turnover = Sales / Average AR
P720,000 / 60,000
=12
ACP =360/AR TO =360/12 =30 Days
A/P Turnover = Purchase / Average A/P
P450,000 / 56,250
=8
APP=360 / A/P Turnover =360 / 8 =45 Days
CCC = 80 + 30 - 45= 65 Days
Funding requirements of the Cash Conversion Cycle
Permanent Funding Requirement - constant investment in operating assets resulting from constant sales over time
Seasonal Funding Requirement - investment operating assets that varies over time as a result of cyclic sales
Aggressive Funding Strategy versus Seasonal Funding Strategy
Aggressive Funding Strategy - seasonal requirements with short term debt
-permanent requirement with long term debt
Seasonal Funding Strategy- seasonal requirement with long term debt
-permanent requirements with long term debt
Example:
Usana company has a permanent funding requirement of P300,000 in operating assets and seasonal funding
requirements that vary between P 0 and P880,000 and average P250,000.
Usana can borrow short term funds at 6.5% and long term at 9%, and if it can earn 5% on the investment of any surplus
balances.
Then, the annual cost of an aggressive strategy for seasonal funding will be:
Aggressive Strategy
Cost of short term financing =0.065 x P250,000 =P16,250
+Cost of long term financing =0.090 x P300,000 =27,000
Total cost of aggressive strategy =P43,250
Conservative Strategy
Surplus = 800,000 - 250,000 =550,000
Cost of long term financing =0.090 x 1,100,000 =99,000
-Eaning on surplus balances =0.050 x 550,000 =27,500
Total Cost of Conservative Strategy =71,500
Collection Float - shorten
Disbursement Float - lengthen
Net Float
