S 1 AUTOMATED GROUP LEARNING AGL AGL NO

S 1 AUTOMATED GROUP LEARNING (AGL) AGL NO. 10 FINANCIAL MANAGEMENT OF WORKING CAPITAL DAILY WORK PACK - PART I Copyright: RGAB/PW 2005/4. 3 AGL

n n n n S 2 WELCOME TO THE PROGRAM a. AGL - two/three days of learning, tested with over 2000 managers in twenty countries around the world. b. Helps you to understand use the reports issued by your finance and accounting division. c. Provides a controlled learning environment where you find the answers to all your questions in the groups and materials provided. e. Requires hard work, but you have fun and learn a lot.

S 3 ABBREVIATIONS n n n n n IND SG CSG MG ASS PL L D LRT CAI - INDIVIDUAL SMALL GROUP COMBINED SMALL GROUP MAIN GROUP ACCOUNTING STEP BY STEP PROGRAM LEARNING LECTURE DISCUSSION LEARNING RECALL TAPE COMPUTER ASSISTED INSTRUCTION

S 4 ASSIGNMENT 1. 0 - INTRODUCTION (30 minutes) 1. 1 SPECIFIC OBJECTIVES n n n The program provides members with the opportunity to understand financial management terms, techniques and reports so that they become more complete managers. This broadening of knowledge and skills will enable them to capitalise on business opportunities and to accelerate their career development.

S 5 1. 1 SPECIFIC OBJECTIVES n a. Understand accounting language and the concepts of financial management. b. Recognize the need for financial forecasting of : cash, funds, income statements and balance sheets. c. Develop practical skills in using financial data to manage working capital effectively. d. Recognize "creative accounting" in financial reporting, despite IAS (International Accounting Standards) and motivate further study in the future n n n n

S 6 1. 2 AUTOMATED GROUP LEARNING (AGL) n n n The AGL method is designed to achieve rapid individual learning using special materials and the stimulus of group activity without a formal instructor. n n n The groups use the materials to find the answers to all problems and questions.

S 7 1. 3 GROUP ARRANGEMENTS n The work will be done: n IND - Individually, or in n SG - Small Group (in small groups of four members which will change daily), or in n CSG - Combined Small Group (two small groups together), or in n MG - Main Group (for short taped lectures on key learning points with visual aids).

S 8 1. 4 SG - SMALL GROUPS n Group n Please names provided on the flip charts. note the name of your SG and names n of the other members.

S 9 1. 5 LEARNING MATERIALS n n n n n (a) Retained by members Text Notebook - for recording every key point Daily Course Diary Learning Recall Tape Articles (2) (b) Used but not retained by members: Daily work packs including: lectures, cases, exercises and key learning points.

S 10 1. 5 LEARNING MATERIALS (continued) n Use your notebook. Do not mark the Daily Workpack which must be handed back at the end of each day. n You receive all the materials in your SG. n Don't look ahead in the workpack until you are specifically asked to do so! n n

S 11 1. 6 METHOD n Try to complete every task in the time allowed. n n A pattern of learning methods will be used including: • Study notes • Case analysis • Lectures • Quizzes • Learning patterns • Homework reading • Learning Recall Tape (LRT) & CAI

S 12 1. 7 LEARNING PATTERNS - REVIEW 1. Objectives Language Ratios Concepts Forecasting Risk & Return Working Capital Creative Accounting CONFIDENCE

S 13 1. 7 LEARNING PATTERNS - REVIEW 2. Learning IND SG CSG MG

S 14 1. 7 LEARNING PATTERNS - REVIEW 3. Methods Study Notes Lectures Small Groups Combined Small Groups Cases & Exercixes LRT Main Group CAI LEARNING FOR YOU

S 15 1. 8 INSTRUCTIONS (15 minutes) n Assemble in SG's to introduce yourself, indicate your past experience in finance and what you hope to contribute to and gain from the course. n Complete the registration sheet in the Daily Course Diary. n NOTE: Please check that you have a full set of learning materials now. n n n

S 16 ASSIGNMENT 3. 0 - STUDY (60 MINUTES) n 3. 1 INSTRUCTIONS - INDIVIDUAL WORK a. Re-assemble in SG and study the lecture and discuss in SG. n b. Record significant points on the flip chart. n c. Review the glossary for any difficulties with new words n d. Record significant points in your noteboo and ssemble in MG when the bell rings n n

S 17 ASSIGNMENT 4. 0 - LECTURE ON FINANCIAL MANAGEMENT n 4. 1 METHOD n Read aloud, listen carefully and respond verbally to n any questions.

S 18 4. 2 FINANCIAL MANAGEMENT n n a. Deals with four major problems: SIZE - what size should the firm be? n n n n GROWTH - what rate of growth of sales, assets, cash flow, profits. etc. ? FINANCING - how should the firm be financed, and at what risk? INVESTMENT - what kind of assets should be acquired, and at what rate?

n n n S 19 4. 2 FINANCIAL MANAGEMENT (continued) b. Most important is. . . CASH FLOW and SURVIVAL. . . to increase the long term VALUE of the business for ALL of the "players": customers, shareholders, management, workers, suppliers, banks, communities, government, trade unions, environmental groups etc

S 19 A 4. 2 n n n n FINANCIAL MANAGEMENT (continued) c. To achieve EVA in a company, the manager of each division must produce: OP/NAE X 100% = above Co. C where: OP = Operating Profit after tax NAE = Net assets employed (FA & CA & OA less CL) Co. C = Cost of Capital

S 19 B 4. 2 FINANCIAL MANAGEMENT (continued) n n n d. The value of a business or a share may be simply computed as: OCF/(r-g) which is explained later. In 1995, shareholders may be powerful pension funds, insurance companies and mutual funds, who may REQUIRE management to provide both dividends and increased share value. . . or move over. . .

n S 20 4. 3 FINANCIAL OBJECTIVE, METHOD AND SKILLS a. business with EVA (Economic Value Added) and SVA (Share Value Added). n n n b. Method - raise money and use it effectively to achieve standards of financial performance c. Skills - risk evaluation, raising cash, using time effectively, and maintaining relationships with the “stakeholders”: customers, employees, owners, bankers, financial markets. government, auditors, community etc. . by developing appropriate attitudes towards risk- taking. n n n Objective - increase the long term value of the

S 21 4. 4 SHORT AND LONG TERM FINANCIAL MANAGEMENT n a. Diagnosis to determine whether business has a short term or long term need for funds n b. Short term: n n n 1. Investment in cash, receivables (debtors) and inventory (stock) 2. Finance from payables (creditors). advances. bank loans etc.

S 22 4. 4 SHORT AND LONG TERM FINANCIAL MANAGEMENT (continued) n c. Long term n 1. Investment in fixed assets, investments, R&D. etc. n n 2. Finance by long term loans or equity. n Note: NET working capital is: n current assets less current liabilities.

S 23 4. 5 FINANCIAL ANALYSIS n n n Use the LAPP system to evaluate the health of a business: Rough Standard Liquidity (and Gearing): Quick assets : quick liabilities 1/2 : 1 Current assets : current liabilities 2: 1 Equity : debt 2 ; 1 or 1 : 1 Activity. S/A (times turned over) Cost of goods sold/Inventory Days of Sales Days of Purchases 1+ 2 -50 30 -90

S 24 4. 5 FINANCIAL ANALYSIS (continued) Rough Standard n n n Proftability: Gross profit/sales x 100% Net profit/owners equity x 100% Operating profit/assets empluyed improving greater than Co. C Note: Rough standards are not adequate! Relate ratios to industry averages. Look at past trends, compare with target. Forecast forward to see the future effect of operations!

S 25 4. 5 FINANCIAL ANALYSIS (continued) n n n n n Potential: Sales Products Markets Facilities Finance Organization Research etc.

S 26 4. 6 FORECASTING FUNDS n Funds flow shows source and use of funds. n Sources are: profit, depreciation, new capital and loans. n Uses are: fixed assets, dividends, working capital. n Funds flow statements reveal key management decisions past and future. n n n Forecast forward to provide funds as required 1 - 5 years ahead.

S 27 4. 7 FORECASTING - CASH n Arrange now for the cash required in the future. n Cash flow is cash (received and paid) in the shorter term. n Continually re-forecast monthly for 12 months ahead to be sure cash is available when required. n n n Some businesses need weekly or even daily cash forecasting and control due to seasonal fluctuations of the industry. Review the past cash flows against target, and plan future cash flows.

S 28 4. 7 FORECASTING - CASH (continued) n Look for peak requirement and duration - watch seasonal and monthly effects. n Don't keep too much cash in hand earning nothing. n Debt capacity (equity: debt relationship) is real KEY to liquidity. n n The quick ratio and current ratio are only part of the story!

S 29 4. 8 MANAGEMENT OF WORKING CAPITAL n (a) Manage the assets and sources of finance: n (b) Assets: n Cash - reduce amount on hand, get it to the bank faster! n Inventory - reduce inventory or get suppliers to hold it! Research high values and slow moving items. . . , n

S 30 4. 8 MANAGEMENT OF WORKING CAPITAL (continued) n n n n Receivables - reduce by credit control, expediting payment, cash discounts, change of customers, deposits, factoring, etc. Identify the long paying receivables. Research the reasons why. . . Invoice errors? Credit note delays? Documents ? Forex? Special needs? . . . Get all the managers (marketing, production, finance etc. ) to “own” the WC problem. .

S 31 4. 8 MANAGEMENT OF WORKING CAPITAL (continued) n (c) Liabilities: n n Suppliers - "stretch" but don't miss discounts; get longer credit; seek alterative suppliers? n Banks - borrow more from the same or several banks? n Leasing - lease rather than buy fixed assets, to release cash for working capital. n

S 32 4. 8 MANAGEMENT OF WORKING CAPITAL (continued) n n Management of short term working capital is the management of CASH FLOW. Watch out for contingent liabilities for: FOREX, legal and environmental claims, lease payments etc.

S 33 4. 8 MANAGEMENT OF WORKING CAPITAL (continued) n n n n n (d) Cash is vital - so many businesses that go bankrupt are making a profit - they just run short of cash. Cash needs vary at different times both within the month and the season. (e) Plan for sustainable positive OCF (Operational Cash Flow) which provides for : increase in working capital needs and “normal” new capital expenditure, A positive OCF makes cash available for new profitable investments that give EVA.

S 34 4. 8 MANAGEMENT OF WORKING CAPITAL (continued) n n (f) "Benchmark" with other companies to set new WC performance standards, Get ALL managers (production, marketing and finance) to "own" the working capital problem!

S 35 4. 9 CHECK LIST ON ANNUAL REPORTS n n n n Be careful with company's annual reports; evaluate reports using a check list: (a) (b) (c) (d) (e) n n (g) n n n (h) Cash, orders and activity Profitability, prospects and resources Long term finance Shareholders and management Exceptional transactions and notes to the financial statements Secret reserves and contingent liabilities for : leasing, legal, environment, FOREX and INTEREST DERIVATIVES etc. Check for reconciliation of net profit with IAS.

S 36 4. 10 SIMPLIFIED COST OF CAPITAL, EVA AND SVA n n n n (a) In very simple terms, the Cost of Capital is the average after-tax cost of raising long term funds for the business. (b) Such funds can come either from long term debt (liabilties) or equity. Normally debt (say 8%) costs less than equity (say 16%). (c) Hence the E: D ratio set by Management (2: 1 or 1: 2) can affect the average Cost of Captial (say 13. 3% or 12% or 9. 3%).

S 37 n n (d) 4. 10 SIMPLIFIED COST OF CAPITAL, EVA AND SVA (continued) EVA (Economic Value Added) is produced when the net assets employed (A-CL) produce an OCF after tax (say 12%) which is greater than the Cost of Capital (say 9. 3%).

S 38 4. 10 SIMPLIFIED COST OF CAPITAL, EVA AND SVA (continued) n EVA (Economic Value Added) is produced when the net assets employed (A-CL) produce an OCF after tax (say 11%) which is greater than the Co. C (SAY 9. 3%). n EVA may be simply computed as V = OCF/(r-g), where: n OCF r g V n n n = Operating Cash Flow (say 100) = Cost of Captal (say 9. 3%) = Growth Rate (say 5. 3%) = 100/(0. 93 -0. 53) = 250

S 39 4. . 10 SIMPLIFIED COST OF CAPITAL, EVA AND SVA (continued) n (e) n n n (f) SVA (Share Value Added) is produced when the sustainable cash flows and dividends lead to increased short term and long term share value. Most companies control capital expenditure well but fail to control investment in WC which is critical to achieving EVA and SVA.

S 40 4. 11 OVERALL (continued) n Plan short term cash and long term needs. n Set financial management objectives. n Manage the WC or it will manage itself - very badly!! n Seek SEVEN alternatives before setting financial policies. n Ensure that short term plans have good long term effects.

S 41 4. 11 OVERALL (continued) n Watch for daily, weekly, monthly and seasonal fluctuations in cash needs! n Seek creative not merely routine financial management. n Always use good financial forecasts 1 -3 years ahead. . . with the key underlying assumptions clearly outlined. n n

S 42 4. 11 OVERALL (continued) n There always SEVEN alternatives. . . n for every financial problem. . . n so, seek them out. . . before. . . n n you make that final decision. . . n and. . . do a PFD. . . before you make the commitment. . .

S 43 4. 12 LEARNING PATTERNS - REVIEW 1. FINANCIAL MANAGEMENT • SIZE • GROWTH • FINANCING • INVESTMENT. . . FOR EVA/SVA

S 44 4. 12 LEARNING PATTERNS - REVIEW 2. W C MANAGEMENT • SOURCES - P and I • USES - C, R and I

S 45 4. 12 LEARNING PATTERNS - REVIEW 3. FINANCIAL ANALYSIS • • L&G A P P

S 46 4. 13 INSTRUCTIONS (10 MINUTES) n (a) Reassemble in SG. n n (b) Study the lecture very carefully and record key points in your notebook. n (c) Discuss any outstanding questions in SG. n (d) When the bell rings carry on with the case study which follows. n

S 47 ASSIGNMENT 6. 0 LECTURE PENELOPE TIMBER CO. (PTC) n n n n 6. 1 STORY OF THE CASE PTC an owner operated wholesale timber merchant of good reputation with two buildings, 20 employees, no sales representatives and annual staff bonuses of 40% of salaries. Increased sales lead to increased receivables and inventory financed by a bank loan and stretching of payables; sales discounts increase but shortage of cash prevents taking purchase discounts. n n Should further planned expansion be financed by bank loans

S 48 6. 2 FINANCIAL HEALTH n a. Liquidity & Gearing : n Quick ratio and current ratios below industry average. n Equity: debt only. 5: 1 (industry 1: 1) n Bank loan 48, 000 insufficient to allow taking purchase discounts; payables stretched; cash extremely short. n

S 49 6. 2 FINANCIAL HEALTH (continued) n n n n b. Activity: Sales/assets ratio above average but inventory turnover weaker; Receivables 38 days (industry 30 days) and payables 85 days (industry 20 days). Very active company possibly over trading for its low equity base.

S 50 6. 2 FINANCIAL HEALTH (continued) n n n c. Profitability: Gross profit percentage to sales falling (12. 2%) but up to industry average (12%). Net profit to owners equity good; very profitable company even after charging very high staff bonuses!

S 51 6. 2 FINANCIAL HEALTH (continued) n d. Potential: n Sales potential good, facilities and staff adequate, . n Management good. n n But finance probably inadequate for the planned expansion.

S 52 6. 3 FUNDS FLOW & OCF n n Funds flow indicates key management decisions on sources and uses of funds; no additional capital. Very little expended on fixed assets and nothing on dividends. n Funds flow confirms the need for further funds to finance a higher level of activity. Will substantial new fixed assets also be necessary soon? n OCF confirms poor EVA focus. n n

S 53 6. 4 EFFECT OF SALES EXPANSION ON FINANCIAL HEALTH n n n n n Sales increase naturally lead to increase in receivables and inventory; high sales cash discounts allowed to get cash quickly. Increased profits substantially distributed to employees as bonus leaving relatively little in the business to finance expansion. In the past assets were financed equally by equity and debt (1: 1) but in the last year financed mainly by liabilities (. 5: 1).

S 54 6. 4 EFFECT OF SALES EXPANSION ON FINANCIAL HEALTH (continued) n Higher leverage and risk of failure! n Sales and profit expansion has led to high profitability, high risk and relatively poor financial health. n n n Cost of losing purchase discounts of 2% 10 days net 30 days is 2%, for the additional 20 days of credit i. e. 36% per annum (365/20 x 2%). . . but only 4% if the 30 days become 182 days. . . 365/182 x 2% = 4%. . .

S 55 6. 5 NEW FORECASTS AND CASH REQUIREMENTS n Underlying assumptions may prove to be not valid: n (a) Gross profit optimistic 14% (last year 12. 2%, industry 12%). {b) Receivables 30 days (last year 30 days). (c) Inventory turnover 5 times (last year 4 times). (d) Bank loan for 48, 000 may not continue. n n n n NOTE: Forecast shows need of 64, 000 but the existing bank may withdraw, thus creating a need for more than 112, 000. Can the company afford to give away so much in sales cash discounts?

S 56 6. 6 PROVIDING NECESSARY CASH n (a) Asset Management n Cash - reduce the minimum cash balance? n Receivables - reduce by: selecting better paying customers, expediting more efficiently, billing on time, changing the cash discount policy, site research visits, error free invoicing, rapid credit note processing, benchmarking, and getting all managers to "own" the problem. n n

S 57 6. 6 PROVIDING NECESSARY CASH n (a) Asset Management (continued} n Inventory - reduce by: getting suppliers to hold inventory, cutting back on requirements, standardisation, JIT, site research visits, benchmarking, and getting all managers to "own" the problem. n n n

S 58 6. 6 PROVIDING NECESSARY CASH (continued) n (b) New Sources n Payables well "stretched' but the discounts lost have cost about 36% p. a. cheaper to borrow from the bank even at 10%! n n n Possible factoring of debtors to get immediate payment for mounts outstanding! n Possible bank loan? n NOTE: Overall, to what extent can planned expansion be cut back to reduce need for funds? n n

S 59 6. 7 FINANCIAL PROBLEMS AND ALTERNATIVES n n Difficult to determine whether the problem is short term or long term without a five year financial forecasts. Initial forecast shows need for at least 64, 000 of additional funds.

S 60 6. 7 FINANCIAL PROBLEMS AND ALTERNATIVES (continued) n n n Profits must be retained in the business to reduce reliance on suppliers (to avoid stretching payables excessively and to take purchase cash discounts). n n n Equity: debt relationship of. 5: 1 is below industry average and therefore not healthy. Could be accepted as a "bridging situation" depending long term finance from profits or new equity; will further fixed assets be necessary with the increasing turnover?

S 61 6. 7 FINANCIAL PROBLEMS AND ALTERNATIVES (continued) n Alternatives available: bank, suppliers, factoring, mortgage, long term loans, new equity, or reduction of assets? n n NOTE: Stretching payables is only cheap after cash discounts already lost, but rather risky; when equity: debt becomes very weak. n Survival may depend more on suppliers than management! n

S 62 6. 8 n n n n DECISION AND JUSTIFICATION (a) Decision - depends upon the risk level which Penelope will accept, his personal objectives for expansion and the possible need to expand merely to survive. If sales can be kept to 1, 200, 000 (not 1, 600, 000) then receivables and inventory could be cut back substantially and very little additional finance needed either from banks or equity.

S 63 6. 8 DECISION AND JUSTIFICATION (continued ) n n n n n If, however, business expansion is vital for survival t hen new funds must finance the increased receivables and inventory. Funds from banks or stretching payables is high risk approach. A lower risk approach to expansion would be to provide new equity funds thus increasing the equity base and improving the general financial health. Bank may refuse new loan and (try to) withdraw existing loan if PTC goes to another bank.

S 64 6. 8 DECISION AND JUSTIFICATION (continued) n n n n (b) Recommendation : increase the equity base now while the business is very profitable; alternatively get a temporary bank loan as "bridging" finance whilst seeking new equity. (c) Justification there is no point in taking excessive risks with a successful business; don't push bank too hard too soon!

S 65 6. 8 DECISION AND JUSTIFICATION (continued n n n Don't pursue sales regardless of financial risk and requirements. NOTE: There are several acceptable alternative solutions; evaluate them in terms of the level of risk PTC should accept!

S 66 6. 9 LEARNING POINTS n n n n (a) Health of the business may be determined ln terms of liquidity (and gearing), activity, profitability and potential. (b) Ratios must be compared with industry averages to determine their significance. (c) Increased sales lead to increased working capital in receivables and inventory.

S 67 6. 9 LEARNING POINTS (continued) n n n n (d) Profits produce funds for financing increased working capital provided they are not distributed as dividends. (e) Working capital may be managed either by reducing the uses, or increasing the sources, of funds. (f) Must determine whether the financial need is short term or long term, since the solutions will differ.

S 68 6. 9 LEARNING POINTS (continued) n (g) Creative financing considers all alternatives before making a decision. n h) Cash flow, funds flow and forecasted income statements and balance sheets help to clarify financial needs. (i) Funds flow reveals key management decisions. n n

S 69 6. 9 LEARNING POINTS (continued) n n (j) "Bridging" finance is short term money pending raising of long term funds. n (k) Management must decide the level of risk that it will accept before deciding upon the expansion and planning the financing. n (l) n n n Financing of working capital easier if company has facilities from more than one bank.

S 70 6. 9 LEARNING POINTS (continued). n n n (m) Always seven alternatives ro every finnncial problem. (n) Cut receivables and inventories in ten ways plus benchmarking and getting all managers to "own" the problem. (o) Research inventory values, turnover, standardisation, supplier cooperation opportunities.

S 71 6. 10 LEARNING PATTERNS 1. SALES EXPANSION – RECEIVABLES + • INVENTORIES + • CASH -

S 72 6. 10 LEARNING PATTERNS (continued) 2. SHORT-TERM TO LONG-TERM PROFIT NOW. . . DISASTER LATER?

S 73 6. 10 LEARNING PATTERNS (continued) 3. WORKING CAPITAL MANAGEMENT PROBLEM "OWNED" BY ALL MANAGERS. . .

S 74 6. 11 INSTRUCTIONS n (a) Re-assemble in CSG n (b) Study the lecture and discuss in CSG. n n (c) Record significant points in your notebook n (d) Reassemble in MG when the bell rings

S 75 ASSIGNMENT 7. 0 - STUDY - FINANCING EXPANSION (75 MINUTES) n 7. 1 INSTRUCTIONS n (a) Re-assemble in new SG, and study the lecture and discuss in SG. n (b) Record significant points on the flip chart. n (c) Review the glossary for any difficulties with new words n (d) Record significant points in your notebook and re-assemble in MG when the bell rings an n n

S 76 ASSIGNMENT 8. 0 - LECTURE ON FINANCING EXPANSION n 8. 1 METHOD n Read aloud, listen , , , n and respond verbally. . . to any questions.

S 77 8. 2 PLANNING FOR THE FUTURE n Need to plan the size, growth and profit stability of the company. n Funds flow is the key to long term financing. n Cash flow is the key to short term financing. n Forecast forward both cash and funds to determine whether financial needs are short term or long term. n

S 78 8. 3 RISK AND THE CRITICAL FEW n Decide upon "critical few" factors which really make for profit in the particular business. Analyze the industry, economy, size of the business and finally the personal values of the chief executive. n Determine the risk level the company will accept. n Evaluate the risk of various possible disasters. n Set financial policies to deal with the "critical few" profit-making features at the appropriate risk level. n n

S 79 8. 4 EFFECT OF EXPANSION n n n Expansion of sales leads naturally to expansion of current assets (receivables, inventory and the minimum cash balance). Management of receivables and inventory is the cheapest "source" of finance, i. e. reduce the investment.

S 80 8. 4 EFFECT OF EXPANSION (continued) n n Suppliers may provide “cheap finance” with or without cash discounts. n Loss of cash discounts is costly - i. e. 2% 10 days net 30 days, is 2% for the extra 20 days of credit or 36% per annum!! n Alternative sources of short term finance include: other suppliers, factoring, loans. customer deposits, banks, etc. n n n Get suppliers to give 2% 30 days or take 9 months to pay or change suppliers?

S 81 8. 5 BANK RELATIONSHIPS n n n n Commercial banks serve customers by financing current business (not like merchant banks which provide long term capital) Key to bank financing is the mutual confidence between banker and customer. Bankers like: short term financing which turns over regularly; they like "accounts" that are actively going from red to black to red, etc.

S 82 8. 5 BANK RELATIONSHIPS (continued) n Banks provide a widening range of services today. n Banks believe that "the customer does not have to tell us all the truth but he must never deliberately lie or be irresponsible". n n n Commercial banks have associates that do merchant banking.

S 83 8. 6 CRITERIA FOR BANK FINANCE n n n Commercial banks lend not just against physical security but on the following criteria: (a) Personal relationship with banker (b) purpose (c) profitability (d) payback (is it possible? ) (e) security. Bankers may say "all loans are repayable on demand if the rules are broken”, but in reality they never demand it , unless in danger. Banks hold security in the hope of NEVER having to use it.

S 84 8. 6 CRITERIA FOR BANK FINANCE (continued) n Banks give information to each other in a special code which is discreet and confidential. n Relationship with the bank manager is the key! n n Banks sometimes insist that "equity base" be increased as a condition for further loans. n Banks are normally conservative and tough! n

S 85 8. 7 CONTROL OF WORKING CAPITAL n n n Frequent (monthly) reporting with reliable financial statements to all managers (production, marketing, finance etc, ) to get them to “own” the WC problem. . n Regular and effective forecasting of peak and duration of cash needs. n Timely financial data. n Forecast forward the income statements, balance sheets, cash and funds flow, and then evaluate risk. n n

S 86 8. 7 CONTROL OF WORKING CAPITAL (continued) n n n Never go to the banker when you need money; go when you don't need money and arrange to have it available when you want it. n n n “I need ECU 500, 000. Can you handle it or should I deal directly with your general manager? "

S 87 8. 8 CONTROL OF RECEIVABLES n n n n n Make frequent aging of receivables to identify slow payers and assess DOS (days of sales) performance. For external causes: visit selected customers to identify the reasons for delay which may include: invoice errors, order errors, credit claim delays, non-delivery, quality issues, INCORRECT DOCUMENTATION etc. For internal causes: investigate, slow invoicing, pricing complexities, credit note delays, shipment errors, poor expediting, discount errors, failure to drop poor accounts etc.

S 88 8. 8 CONTROL OF RECEIVABLES n n Benchmark with other companies in collaboration with marketing, production, quality, finance managers to jointly: “own” the problem, set targets and monitor progress.

S 89 8. 9 CONTROL OF INVENTORY n n n n Make frequent aging of inventories to identify slow moving high value items and to assess DOP (days of purchases) and DOS (days of sales) performance. For external causes: visit selected suppliers to identify the reasons for high inventory which may include: excess order quantities, long delivery lead times, poor standardization, lack of JIT systems etc.

S 90 8. 9 CONTROL OF INVENTORY (continued) n n n n For internal causes: investigate delayed usage, excess storage, lack of standardization, poor design specification, failure to control high value items daily, excess storage space/costs, poor standardisation, lack of JIT systems, poor supplier selection etc. Benchmark with other companies in collaboration with marketing, production, quality, finance managers to jointly: “own” the problem, set targets and monitor progress.

S 91 8. 10 INFLUENCE OF THE CHIEF EXECUTIVE n n n n Age. experience, reputation, skills, attitudes and knowledge of the chief executive are key factors in the decision to finance expansion by banks. suppliers or merely reduce the working capital investment. Overall expansion of sales involves increase in assets employed in the business; financing of those assets is a management decision; but there always many alternatives.

S 92 8. 10 INFLUENCE OF THE CHIEF EXECUTIVE (continued) n n "Bridging" of long term needs by short term finance is cceptable provided the risk is clearly recognized and there is an achievable long term plan to recover financial health.

S 93 8. 10 INFLUENCE OF THE CHIEF EXECUTIVE (continued) n n n n May accept temporary high risk, and unhealthy financial position provided: high profits, planned recovery of health planned reduction of risk to "normal" level. Note: Before every financial negotiation, always make other contacts to work out what you could do WITHOUT the other party. . . then negotiate (gently) from strength. . . not weakness. . . because you have good alternatives. . . without him/her. . .

S 94 8. 10 INFLUENCE OF THE CHIEF EXECUTIVE (continued) n n n n Management have a high “ego” priority to use “excess cash” for expansion and diversfication projects. By contrast shareholders may have priority for EVA targets in terms of dividends and SVA. Thus the sharehiolders may insist that unless new acquisitions or mergers can achieve EVA then the excess cash is bette returned to shareholders as dividends or share buy-back (equity reduction).

S 95 8. 11 LEARNING PATTERNS - REVIEW 1. BANK FINANCING PPPP&S

S 87 8. 11 LEARNING PATTERNS - REVIEW (continued) 2. CONTROL OF R & I INTERNAL EXTERNAL

S 88 8. 11 LEARNING PATTERNS - REVIEW (continued) 3. CEO CHIEF CUSTOMERS EXECUTIVE EMPLOYEES OFFICER OWNERS

S 89 8. 12 INSTRUCTIONS (10 MINUTES) n (a) Reassemble in SG n (b) Study the lecture carefully n (c) Record key points in your notebook n (d) Discuss outstanding questions n (e) When the bell rings, carry on with the case study which follows n

S 90 ASSIGNMENT 10. 0 LECTURE ON LUMSDEN (A) n 10. 1 STORY OF THE CASE n Expansion financed by long term bank loan 140, 000 capital expenditure and 160, 000 for working capital. n n Lumsden commits for increased capital expenditure of about 400, 000 before consulting the bank and thus breaks the agreement.

S 91 10. 2 HEALTH OF THE COMPANY n (a) Liquidity & Gearing n Quick ratio is a little weak, although stronger than previous years; current ratio is strong. n n Equity: debt ratio of 2. 4: 1 is very strong indeed, both compared with previous years and the industry. n n n Overall, fairly liquid and well able to meet its commitments at the present level of operations.

S 92 10. 2 HEALTH OF THE COMPANY (continued) n (b) Activity n Turnover of assets and inventories fair. n Receivables better than industry average. n Payables settled with cash discounts; overall, a fairly active company. n

S 93 10. 2 HEALTH OF THE COMPANY (continued) n (c) Profitability n Gross profit percentage very high in the first seven months (un-audited!). n n Similarly net profit to sales higher than the industry (why? manipulated? ). n Overall return on equity is very good. n Subject to possible manipulation of inventory value (need an audit), profitability seems very good indeed. n n

S 94 10. 2 HEALTH OF THE COMPANY (continued) n n n (d) Potential Market potential good; management effective but a little old and unreliable; production expanding. NOTE: Overall a healthy company, with cash and funds flow adequate to finance current operations.

S 95 10. 3 FUNDS FLOW & OCF n Funds flow indicates major management decisions regarding source and use of funds. n Only a small past increase working capital, since profits mainly used for fixed assets and mortgage repayments. n n n Funds raised from the bank to finance fixed assets and working capital expansion. Is this wise? Substantial increase in assets financed largely by accruals for taxes; no draining off of profits into dividends. Confirmed by OCF.

S 96 10. 4 ORIGINAL BANK LOAN n n n Criteria for bank finance: (a) Personal relationship with the bank Lumsden well known to the bank for some years but a little old (health risk? ). (b) Purpose : expansion to meet outstanding orders; market seems to warrant such expansion. (c) Profitability : company very profitable and healthy.

S 97 10. 4 ORIGINAL BANK LOAN (continued) n n n n (d) Payback no drain. off of profits into dividends; profitability should enable payback in the time allowed. (e) Security general security of the business including property, inventory, etc. seems adequate for the loan. NOTE: Lumsden well qualified for the original loan of 140, 000 for capital expenditure and 160, 000 for working capital; bank acted wisely in making loan because it met the criteria.

S 98 10. 5 BANK AGREEMENT n n n n Lumsden has broken the bank agreement because he has committed for more than 140, 000 of new capital expenditure; bank could call in loan immediately. Bank only committed in Sept last year to 80, 000 outstanding; could be repaid with no loss to the bank. The substantial cash balance could be immediately offset against the loan and Lumsden could get finance from another bank or financial source.

S 99 10. 5 BANK AGREEMENT(continued) n n n New cash needed for fixed assets is 400, 000 and working capital 160, 000, but no forecasts available for five years to ensure these amounts will be adequate. n Is the estimate of 400, 000 reliable for a new plant? Will 160, 000 be adequate for working capital if sales increase from 1 to 3 million? n Probably more money needed. n n

S 100 10. 6 FURTHER BANK FINANCE n (a) Criteria for a new loan: n Personal relationship with the bank : n Lumsden broke his agreement once and therefore can he be relied upon in the future? Is the breach a serious one? Probably not since only 80, 000 is outstanding at the moment. n n n Can Lumsden manage bigger plant? Labor problems? Can he adapt to new scale of operations which is three times what he is used to? He is quite old and may find it difficult.

S 101 10. 6 FURTHER BANK FINANCE (continued) n n Purpose: additional plant to meet market need; Lumsden only a "marginal supplier" and the economy might turn down. Profitability: Lumsden still profitable but no audited accounts available for last year.

S 102 10. 6 FURTHER BANK FINANCE (continued) n n n Payback: larger amount harder to pay back out of profits; depends upon the general success of Lumsden and good cash flow from profits. Security: still fairly strong since the plant could be sold if necessary; less security for a larger loan than a smaller one.

S 103 10. 6 FURTHER BANK FINANCE (continued) n n n n n NOTE: Overall, Lumsden still a good financial risk, subject to his ability to work well with the bank and to restrain himself from excessive expansion and meet new business management problems! Total money requirement probably higher because of the uncertainty; loan terms should tryn to restrict Lumsden's activities and require very close reporting and control. Bank policy is to be aggressive in seeking and keeping clients.

S 104 10. 6 FURTHER BANK FINANCE (continued) n n n n n (b) Alternatives open to Lumsden: Get the money from another bank Get loans from suppliers of equipment Factor receivables Lease rather than buy the plant Raise new equity but keep control of the company Don't expand Sell out NOTE: Many opportunities open to Lumsden if the bank refuses.

S 105 10. 7 FINANCIAL POLICIES n (a) Lumsden n Recognize the risks involved in such extensive expansion; play safe by increasing equity base now but keep control of the company. n n n Set up alternative financial sources to avoid reliance on one lender. Consider leasing the plant rather than buying it. Achieve better relationship with the bank or with several banks to provide flexibility (and strength!)

S 106 10. 7 FINANCIAL POLICIES (continued) n n n Overall accept the loan if offered, but keep to the terms and seek equity soon while the company is still healthy and profitable. NOTE: ALWAYS SET UP ALTERNATIVE FINANCING. . . BEFORE. . . NEGOTIATING WITH A BANK. . . NEGOTIATE FROM STRENGTH. . . NOT WEAKNESS. . . !!!

S 107 10. 7 FINANCIAL POLICIES (continued) n (b) Bank n Decide if Lumsden can be relied upon to remain a good client; if not, reclaim the money immediately and seek business elsewhere. n n n n If Lumsden remains a client, give the loan provided he also increases the equity base! Set controls upon him in terms of monthly audited reporting and inspection of the plant, to ensure that the bank is well informed of developments in time.

S 108 10. 7 FINANCIAL POLICIES (continued) n n n (c) Justification Expansion by bank finance is "bridging" until more equity financing can be found. In the future avoid commitment before providing financial resources.

S 109 10. 7 FINANCIAL POLICIES (continued) n n NOTE: Always do a PFD before activity major financial decisions, to check again the underlying assumptions: economic, marketing, technical, financial, management etc. and the possible EI. . .

S 110 10. 8 n n LEARNING POINTS (a) Criteria for bank lending includes: personal relationship, purpose, profitability, payback and security. n (b) Breach of a bank loan agreement, gives the bank the right to reclaim money immediately and to offset all balances. n (c) Bank confidence in the client is key to bank financing. n n

S 111 10. 8 LEARNING POINTS (continued) n n n n (d) Many alternatives for financing of working capital including reduction of activity, factoring, financing by supp liers, leasing, etc. (e) Set up alternative financial plans before negotiating a final deal, so as to be flexible to negotiate from strength. (f) No need to own the whole business and keep all the profits. Increasing the equity base of the business means sharing: profits, risks and losses.

S 112 10. 8 LEARNING POINTS (continued) n n (g) Financial control involves regular, reliable and timely monthly or weekly data, audited when necessary. n (h) "Bridging" finance provides short term resources pending long term financing arrangements. n (i) n n Need financial forecasts for five years ahead to determine whether problems are short term or long term.

S 113 10. 8 LEARNING POINTS (continued) n n n (j) Unaudited financial statements are not reliable; they may have been manipulated. (k) Think creatively about financing problems and seek out all (SEVEN) alternatives before making a critical fianancial decision.

S 114 10. 8 LEARNING POINTS (continued) n n (l) Decide very carefully about the extent and duration of the risk level to be accepted. n (m) Keep options and relationships open. n (n) Benchmark to help to set better standards for working capital management. n

S 115 10. 9 LEARNING PATTERNS 1. MAXIMISING GOALS SALES PROFITS CASH FLOW SVA. . .

S 116 10. 9 LEARNING PATTERNS (continued) 2. INVESTMENT MUST RETURN ABOVE C. OF C. FIXED INVESTMENT - WELL CONTROLLED WC INVESTMENT NOT CONTROLLED. . .

S 117 10. 9 LEARNING PATTERNS (continued) 3. FINANCIAL MANAGEMENT SKILLS TIMING. . .

S 118 10. 10 INSTRUCTIONS n (a) Re-assemble in CSG n (b) Study the lecture and discuss in CSG. n (c) Record significant points in your notebook n (d) Reassemble in MG when the bell rings.

S 119 ASSIGNMENT 11. 0 - SUMMARY LECTURE FOR PART I n 11. 1 FINANCIAL MANAGEMENT n (a) Deals with four major problems: n n 1. 2. 3. n n n 4. Size - what size should the firm be? Growth - what rate of growth of sales, assets, profits. etc. ? Financing - how should the firm be financed, and at what risk? Investment - what kind of assets should be acquired, and at what rate?

S 120 11. 1 FINANCIAL MANAGEMENT n n n (b) Financial health of the business depends upon both its resources, the environment in which it operates and its financial policies. Financial management is dynamic and depends upon flows or cash and funds not a static situation.

S 121 11. 1 FINANCIAL MANAGEMENT (continued) n n n (c) Most important is. . . CASH FLOW and SURVIVAL. . . to increase the long term VALUE of the business for ALL of the "stakeholders": customers, shareholders, management, workers, suppliers, banks, communities, government, trade unions, environmental groups etc.

S 122 11. 1 FINANCIAL MANAGEMENT (continued) n n n n (d) To achieve EVA in a company, the manager of each division must produce: OP/NAE X 100% = above Co. C where: OP = Operating Profit after tax NAE = Net Assets Employed (FA & CA & OA less CL) Co. C = Cost of Capital

S 122 A 4. 2 FINANCIAL MANAGEMENT (continued) n (e) The value of a business or a share may be simply computed as: OCF/(r-g) , n (f n n n In quoted companies, shareholders may be powerful pension funds, insurance companies and mutual funds, who are highly skilled in finance ; they may require management to provide both dividends and increased share value. . . or move over. . . thus in 1995, SVA is becoming a key financial objective!

S 123 11. 2 OBJECTIVE, METHOD AND SKILLS n a. Objective - increase the long term value of the business with EVA (Economic Value Added) and SVA (Share Value Added). b. Method - raise money and use it effectively to achieve standards of financial performance c. Skills - timing to balance risk and reward n n n

S 124 11. 3 SHORT TERM/LONG TERM FINANCING n n n n n (a) Short term finance used for: cash, receivables, inventory. prepayments, etc. (b) Sources of short term finance: suppliers, banks, factoring, leasing, or reduction of the need for cash, receivables and inventory. (c) Long term financing deals with long term assets and the financing of those assets by proportions of equity and debt.

S 125 11. 4 FORECASTING n n (a) Cash forecasting used to provide cash resources up to one year ahead. Concentrate on the duration and peak need within: weekly, monthly, yearly, seasonal, etc. periods

S 126 11. 4 FORECASTING (continued) n Distinguish: n CF n EBIT - earnings before interest and taxes n OCF - operating cash flow - cash flow plus interest, less working capital changes, less “normal” capital expenditure. Often called “Free Cash Flow” because it is cash availble for new profitable investment opportunities. n n - cash flow - net profit plus depreciation

S 127 11. 4 FORECASTING n n n n (b) Funds flow reveals the key financial decisions of past and future. Sources of funds: profit. depreciation. new equity and long term loans. Uses of funds: fixed assets, dividends, repaymen of long term loans and working capital. Net working capital is: current assets less current Liabilities.

S 128 11. 4 FORECASTING (continued) n n n (c) Forecasted income statements and balance sheets reveal future financial health. (d) Materiality is the key - concentrate on large amounts and long time periods. Don't get involved with the peanuts. . . ! Small errors don't matter at all. . . !

S 129 11. 5 BANK RELATIONSHIPS n n n n n (a) Relationship with the banker is key to the management of working capital. (b) Criteria for bank loans: person, purpose, profitability, payback, and then security. (c) Many alternatives available to bank finance (they may cost more): factoring, deposits. loans, leasing. stretching creditors, other banks, etc. (d) Old bank customers normally get better treatment than new ones. Cultivate a relationship with your bank manager.

S 130 11. 6 FINANCIAL ANALYSIS n n (a) LAPP system of financial analysis: liquidity (and gearing), activity, profitability, potential. n (b) Need to forecast cash and funds and provide adequate flows to finance assets acquired and required. n (c) Be creative in seeking and using financial alternatives. n (d) Avoid "emotional investment" n

S 131 11. 7 CONTROL OF WORKING CAPITAL n n Frequent (monthly) reporting with reliable financial statements to all managers (production, marketing, finance etc. ) to get them ALL to “own” the WC problem. . n Regular and effective forecasting of peak and duration of cash needs. n Timely financial data. n Forecast forward the income statements, balance sheets, cash and funds flow, and then evaluate risk. n n

S 132 11. 7 CONTROL OF WORKING CAPITAL (continued) n n n Never go to the banker when you need money; go when you don't need money and arrange to have it available when you want it. n n n “I need ECU 500, 000. Can you handle it or should I deal directly with your general manager? "

S 133 11. 8 CONTROL OF RECEIVABLES n n n Make frequent aging of receivables to identify slow payers and assess DOS (days of sales) performance. For external causes: visit selected customers to identify the reasons for delay which may include: invoice errors, order errors, credit note claims, non-delivery, quality issues, incorrect documentation etc.

S 134 11. 8 CONTROL OF RECEIVABLES (continued) n n n n n For internal causes: investigate, slow invoicing, pricing complexities and errors, credit note delays, shipment errors, poor expediting, discount errors, failure to drop poor accounts etc. Benchmark with other companies in collaboration with marketing, production, quality, finance managers to jointly: 1. 2. 3. “Own” the WC problem Set targets, and Monitor progress.

S 135 11. 9 CONTROL OF INVENTORY n n n n Make frequent aging of inventories to identify slow moving high value items and to assess DOP (days of purchases) and DOS (days of sales) performance. For external causes: visit selected suppliers to identify the reasons for high inventory which may include: excess order quantities, long delivery lead times, poor standardization, lack of JIT systems etc.

S 136 11. 9 CONTROL OF INVENTORY (continued) n For internal causes: n Investigate delayed usage, excess storage, poor standardization, poor design specification, failure to control high value items daily, excess storage space/costs, lack of JIT systems, poor supplier selection etc. n n n Benchmark with other companies in collaboration with marketing, production, quality, finance managers to jointly: “own” the problem, set targets and monitor progress.

S 137 11. 10 SIMPLIFIED COST OF CAPITAL, EVA AND SVA n n n n (a) In very simple terms, the Cost of Capital is the average after-tax cost of raising long term funds for the business. (b) Such funds can be either from long term debt (liabilties) or equity. Normally debt (say 8%) costs less than equity (say 16%). (c) Hence the E: D ratio set by Management (2: 1 or 1: 2) can affect the average Cost of Captial (say 13. 3% or 12% or 9. 3%).

S 138 11. 10 SIMPLIFIED COST OF CAPITAL, EVA AND SVA (continued) n EVA (Economic Value Added) is produced when the net assets employed (A-CL) produce an OCF (Operating Cash Flow) (say 11%) which is greater than the Co. C (Cost of Capital) (Say 9. 3%). n EVA may be simply computed as V = OCF/(r-g), where: n n n n OCF r g V = = Operating Cash Flow (say 100) Cost of Captal (say 9. 3%) Growth Rate (say 5. 3%) 100/(0. 93 -0. 53) = 250

S 139 11. 10 SIMPLIFIED COST OF CAPITAL, EVA AND SVA (continued) n (e) SVA (Share Value Added) is produced when the sustainable cash flows and dividends lead to increased short term and long term share value. ) (f) Working capital management is critical to achieving EVA and SVA. n n n n (g) And thus any INCREASE in working capital is an INVESTMENT that must be justified, like any other capital investment or acquisition, by a return, that exceeds the Cost of Capital.

S 140 11. 11 DIAGNOSIS AND DECISION n n n (a) Recognize that every industry and trade and country has a special tractional environment and standards of financial management. (b) Knowledge, attitudes, and skills, force the financial manager to be creative.

S 141 11. 11 DIAGNOSIS AND DECISION (continued) n n n (c) Diagnosis helps the financial manager to distinguish short term from long term problems. (d) Ensure that short term financial policies arc consistent with long term goals. (e) Provide for both short term and long term financial health at appropriate risk levels.

S 142 11. 11 DIAGNOSIS AND DECISION (continued) n n (f) Manage the working capital. . . or it will manage itself - very badly! (g) Seek all (seven) alternatives before setting financial policies.

S 143 11. 11 DIAGNOSIS AND DECISION (continued) n NOTE: n Past attitudes may deter new financial policies for reducing assets or using increasing NEW sources of finance. n

S 144 11. 12 LEARNING PATTERNS - REVIEW 1. FINANCIAL MANAGEMENT S, G, F & I. . . CASH FLOW. . EVA/SVA

S 145 11. 12 LEARNING PATTERNS - REVIEW (continued) 2. COST OF CAPITAL AVERAGE COST OF EQUITY AND DEBT (LIABILITIES) HURDLE RATE FOR EVA

S 146 11. 12 LEARNING PATTERNS - REVIEW (continued) 3. OPERATING CASH FLOW PROVIDES CASH FOR: WC & “NORMAL” CAPITAL INVESTMENT AND NEW PROFITABLE INVESTMENT OPPORTUNITIES FOR EVA INCREASED WC IS AN INVESTMENT!

S 147 11. 13 INSTRUCTIONS (20 minutes) n Reassemble in SG n Review the Summary Lecture for Part I in the course n diary and discuss questions arising n To get the best out of Part II of the program, try to n complete ALL of the following. . . homework tonight. . .

S 148 11. 13 INSTRUCTIONS (continued). . . homework tonight. . . n Read the articles on finance n In the ASS text, review the chapter summaries and the glossary n n Do the optional exercises in the course diary and check the answers n Review the summary lecture for Part I in the course diary n Review your notes for Part I of the course and list outstanding questions to be resolved in Part II n n

S 149 11. 13 INSTRUCTIONS (continued) Final Note for Part I. . . Thank you for working so hard today. . Tomorrow. . it’s downhill all the way. .