LU 8 - Liquidity Risk Management PDF

CHAPTER 11 Liquidity risk Management In the opening case study, we saw that Construct Company expected a cash shortage at the end of each month (January to March) of R56 million, R153 million and R56 million, respectively. This is a problem as the company only has an overdraft facility of R50 milli...

CHAPTER 11 Liquidity risk Management In the opening case study, we saw that Construct Company expected a cash shortage at the end of each month (January to March) of R56 million, R153 million and R56 million, respectively. This is a problem as the company only has an overdraft facility of R50 million and will therefore clearly experience cash flow problems.  Learning outcomes Once you have worked through this chapter, you should be able to do the following: Explain the terms and elements of liquidity management. Demonstrate understanding of the importance of the availability of cash and cash equivalents for an enterprise and the reasons for holding cash. Understand the concept of the working capital cycle and calculate the cycle in given circumstances. Identify and critique the different working capital policies and be aware of the factors that need to be considered when formulating a working capital policy. Understand the effect of working capital policy on an organisation’s operational efficiency, liquidity risk and profitability  Learning outcomes Once you have worked through this chapter, you should be able to do the following: Forecast working capital requirements. Discuss the facets of inventory management, including competing objectives that need to be managed and inventory management systems. Discuss the facets of debtor management, including competing objectives, costs of credit sales and credit policy as well as credit risk and debt collection. Discuss the facets of creditor management, including competing objectives and strategies for managing creditors. Discuss the facets of cash management, including competing objectives, cash budgeting, cash planning and various cash management techniques. Prepare a cash budget and adjust for cash shortages. Introduction ❑Companies often make profits on paper, but if they do not have the cash to sustain their operations, they cannot continue to do business. ❑For example, a company might make sales on credit, meaning they have not yet received cash for those sales. ❑Liquidity management is management decisions aimed at ensuring that an organisation has sufficient cash to finance its day-to-day operations. ❑To sustain its operations, a business has to meet its short-term obligations. ❑Liquidity management is all about balancing opposing and competing objectives. Why manage net working capital? ❑Operating efficiency ❑Holding cash and managing liquidity risk ❑The effect of net working capital on profitability Working capital Cycle ❑Working capital cycle for a business, also referred to as the cash conversion cycle. ❑Cash conversion cycle measure the number of days it takes a company to convert inventory into cash. Working capital cycle In order to determine how long it will take a company to complete its working capital cycle, we need to establish how long the company takes to do the following: ❑Sell its inventory ❑Settle its creditors ❑Collect its debts This can be established by determining the following liquidity ratios ❑Inventory turnover in days (want this to be small as possible) ❑Debtors’ collection in days (want this to be small as possible) ❑Creditors’ payment period in days (want this to be as big as possible) Calculating the CCC Class Example Solution Class Example Solution How management can reduce the CCC ❑Shortening either the average age of inventory or the average collection period or lengthening the average payment period or a combination of these, can reduce CCC. Creditor Management ❑These are creditors who come into existence as a result of buying inventory on credit from receiving services of credit. ❑creditors must be managed to ensure company does not have too much debt. ❑ It determines whether it is cheaper to borrow from the bank and pay the supplier immediately or to “borrow” from the supplier by buying on credit. Competing objectives: Take longer to pay to benefit cash flow Pay earlier to build good relationships Strategies for managing creditors: Make use of free credit Build relationships Well managed IT system Creditor Management In the same way that a company gives credit terms to its debtors, creditors also give credit terms to a company. It is expressed in the same way, e.g. 2/10 net 30 Class Example Class Example Inventory Management ❑Inventories normally consist of raw materials, work in progress, finished goods and in some cases consumables. ❑Without inventory such as raw material and work in progress, a business would be unable to produce its goods. ❑Without finished goods, the business would be unable to generate sales. Inventory Management Competing objectives: Too little ▪ It can be harmful to the image of a company if they do not have enough goods to sell to customers. ▪ Production will stop if the company does not have sufficient raw materials to be able to manufacture its products. Too much ▪ Perishable inventory items can spoil. ▪ All types of inventory can be destroyed in a disaster. ▪ Where there is a lot of development, like technology, inventory can become obsolete so that customers won’t want to buy it anymore. s Inventory management Inventory management systems EOQ JIT Supply chain management Inventory Management: Economic Order Quantity ❑The Economic Order Quantity (EOQ) can be used to evaluate the best quantity of inventory to purchase at a time to reduce the costs of holding and ordering inventory. ❑The EOQ thus calculates the optimal number of units of inventory that needs to be ordered so that costs are kept to a minimum. Inventory Management: Economic Order Quantity ❑Essentially, the economic order quantity assumes that there are two main costs associated with inventory: carrying cost (or holding cost) and ordering cost. Carrying costs ▪ Costs that a company incurs to keep inventory, like warehousing costs, financing cost, insurance and the cost of obsolete inventory. The more inventories a company holds, the higher this cost will be. Ordering costs ▪ Costs of placing and receiving an order for inventory, for example, handling and transport. Most of these costs increase with smaller, less frequent orders. Inventory Management: Economic Order Quantity ❑The EOQ is calculated by using the following formula: Where: OC = fixed costs of placing and receiving an order AS = Annual sales in units CC = Annual cost of carrying one unit Methods to manage inventory ❑Another useful concept that helps to ensure a company has the right amount of inventory at the right time is the reorder point. ❑The reorder point is the point of inventory at which an order should be placed. ❑It is calculated by using the following equation: Reorder point = lead time x daily usage Class Example Class Example Class Example Just-in-time (JIT) inventory management Just-in-time (JIT) is a production model that, among other things, requires delivery of inventory as it is required. This practice obviously reduces the carrying cost associated with high inventory levels. The Firm should strive to carry little or no inventory. South Africa companies have difficulty implementing the JIT model as there are factors that frequently cause delays in production cycles Reliance on Slower Road transport, frustrated further by constant roadworks Power shortages Labour disputes Supply chain management Supply chain management is the management of the flow of goods from the acquisition of the raw material to the final distribution of goods to the end consumer. Cash Management Competing objectives: There has to be sufficient cash in order for management to be able to sustain the entity’s daily operations, to finance continued growth and to provide for unexpected payments. The business can reduce its return by holding too much money. Techniques: Cash budget Managing cash shortages Increase cash inflows Decrease cash outflows Obtain bridging financing Cash budget The cash budget is the main tool for managing the cash of a business. The cash budget forecasts the cash receipts and cash payments of the business and determines the closing balance of cash and cash equivalent held by the business at the end of each period. Based on estimated figures rather than actual amounts – company can plan its expenditure and avoid cash deficit Cash budget Cash inflows – all the cash expected to come into a company ▪ Cash sales ▪ Receipts from debtors ▪ Interest received Cash outflows – all the cash expected to go out a company ▪ Purchases of inventory ▪ Salaries and wages ▪ Purchases of assets Class Example Managing cash shortages When managers foresee a cash flow problem, they can choose one or more of the following options: Increase cash inflows Decrease cash outflows Obtain bridging finance Managing cash shortages Reason why a business hold cash Debtors Management Debtors can be a large component of an entity’s working capital. Competing objectives: ▪ The sales manager would like to see more lenient credit policy to attract more customers so that he or she can meet sales targets. ▪ The credit controller would like a stricter credit policy to reduce the level of bad debts Cost involved ❑Opportunity cost for receiving money later ❑Financing cost ❑Bad debt ❑Settlement discounts Debtors Management Credit policy considerations Asses credit risk ❑ Past commitment to honouring debt obligation on time ❑ Past credit history and ability to meet payments ❑ Financial position ❑ Available security in case of default in payment. Settlement and collection of debts ❑Debt collection policy stipulates the actions that the business will take against debtors at each stage of collection process ❑Management may decide to incentivise early settlement of debtor accounts by providing settlement discount. Debtors Management Example 8 Debtors Management Factoring ❑An entity can sell its trade debtors (also known as trade receivables) to another business. Example 9 HOMEWORK FROM THE PRESCRIBED TEXTBOOK: ACTIVITY - SHORT QUESTIONS: 2,6,7 & 10 - LONG QUESTIONS : 5