Investing short-term funds, by short-term funds
we refer to funds that are not necessarily needed
in a company's daily transactions. On the previous
slide we were talking about funds that were needed
for daily transactions, and we called those funds
cash, practically speaking that would be money that
sits in the current account of a company. Short-term
working capital portfolios consist of securities
that are highly liquid, less risky and shorter in
maturity than other types of investment portfolios.
Generally working capital portfolios consist
of short-term government securities and short-term
bank and corporate obligations. You can think of these
securities as securities that can be converted into
cash within 2 or 3 days. Examples of short-term securities
or short-term Investments are given in example
7, but in most countries the popular short term investment
would be government t-bills. You need to be able to
calculate the yield on short-term investments.
If you are running a corporate finance function
at a company, then you will be making short-term
investments and you need to understand the yields or
the returns that you are getting. This material should
look familiar because we covered this in quantitative
methods. Let's say that you want to invest in a US
t-bill and a 90-day $ 100,000 t-bill
is purchased at a discount rate of 4%. You need to calculate
the money market yield and the bond equivalent yield
Again, these terms should look familiar. What does the discount rate of 4%
mean? Does this mean that you are actually getting
the return of 4%? And if you remember correctly the
return that you are getting is not 4% because the
discount yield or a discount rate refers to a discount
relative to face value. So we can actually use this
formula to come up with how much you are paying for
the security and then based on how much you are paying
for the security, you can calculate the money market
yield and the bond equivalent yield. So let's do the calculation.
The face value or the par value is 100,000.
100,000; for simplicity I will just work
in thousands. 100 minus the price that you pay,
this is the discount, divided by the face value which is 100
* 360 / t. t is the time remaining to maturity, for a 90-day
t-bill that would be 90. This is equal to 4% of 0.04
The 100 - P represented the discount and if you do the
math, you should get discount equal to 1000 which
means that the price that you are paying is equal
to 99,000. You can now use the price 99,000 to come
up with the money market yield. The money market
yield is the par value which is given by F or the face
value minus P which is 99. So we have 1,000 / the price
99,000 * 360 / t. t is 90 days and what you get over here
is 0.0404 which is 4.04%. Notice that the money market
yield is a little bit higher than the discount basis
yield of 4%. Then we calculate the bond equivalent yield
using this formula, the discount, which is 1 / 99.
Into 365 over 90 because we are using 365 days rather
than 360 days, this number now is going to be a little
bit larger. Here I want to point out that the formula
given here for bond equivalent yield is different
from the formula that we saw in quantitative methods
and it is different from the formula that we'll see
later in fixed-income. In quant and fixed-income
bond equivalent yield is given as two times the semi
annual yield. This is a little bit confusing. But
what I would say is if you get a question on bond equivalent
yield in the corporate finance section of your exam
then use this formula otherwise use the formula
that we have seen in quant and the formula that you
will see in fixed-income. If you have trouble memorizing
too many formulas, then memorize this one because
this formula is more accurate. Strategies for managing
short-term investments and how do you evaluate
your performance? The objective of short-term
investments is to earn a reasonable return while
taking on limited credit risk and limited liquidity
risk. Credit risk is the risk that the counterparty will
default in some form and this is the topic that we'll
see in a lot of detail in fixed-income, but it's fairly
obvious that when a company is making short-term
investments it wants to be able to liquidate very
fast and obviously a company does not want to take
the risk that the counterparty will default. That's
why generally short-term funds are invested in
government securities or securities of companies
that have a very good credit rating. Liquidity risk refers to the risk
of not being able to convert your investment into
cash at market value. And again given that a company
wants to be able to quickly convert its investment
into cash, generally speaking companies will
not want to take on liquidity risk. Companies should
create an investment policy statement or an IPS. This
statement should clearly identify the purpose
or the objective, the authorities so who has the authority
to invest how much, what are the limitations and restrictions
in terms of the sorts of investments that can be made
and so on. This is a fairly elaborate topic and we
will cover it in more detail when we do portfolio
management. My suggestion to you is read exhibit
9 and example 3, which will give you a good sense for
dealing with an IPS in this context. Short-term strategies
can be passive or active. Passive strategies focus
on rules. There might be around which says that short-term
investments can only be made in government securities
or more specifically investments can only be made
in 3 months t-bills and 6 months t-bills. Generally
the rules focus on safety and liquidity. Active strategies
are more aggressive and require constant monitoring,
there are different subtypes of active strategies
which include matching, mismatching and laddering.
Very simplistically with matching we are trying
to identify our cash needs and making investments
based on our cash needs and essentially matching the
inflow of cash with outflow. In other words, if a
company knows that it will need a certain amount
of cash after 90 days, then it would make sense to
invest in a 90-day t-bill now so that when the t-bill
matures in 90 days, the cash can be used to pay off the
obligation. That is a very simple example. Finally,
how do we evaluate short-term funds management?
Say you are an analyst and you want to evaluate how well the corporate
finance function of a given company is doing
and more specifically you want to evaluate their
short-term funds management. Here is what you need
to do. You need to look at the various investments
that are being made and then compute the weighted average
of the investments. In terms of the yield that you
use you should use the bond equivalent yields because
that is how most investments are quoted. Important point is
to be consistent. So if a company makes three investments
A, B and C, for each of those investments you need to
know what is the bond equivalent yield so say the
bond equivalent yield is 5%, 6% and 7% you then take
a weighted average of the three. If simplistically
these three are all equally weighted then you simply have
a weighted average of 6. Compare this yield with a benchmark
rate. We don't need to get into too much detail here.
But just imagine that there is a benchmark rate which
is made available to you, which is a standard rate
or a short-term rate. You need to then compare this
6% with a short-term benchmark rate. From an exam
perspective that short-term benchmark rate will be given
to you. In the real world, you will need to figure out
what the appropriate benchmark rate is. Take a look
at exhibit 10 in the curriculum, this is a short
exhibit which comes up with a weighted average rate
and the benchmark rate is given, the weighted-average
is then simply compared with the benchmark. If the
weighted average rate is below the benchmark rate
that means that short-term funds are not being managed
very well. Managing accounts receivables: There are three
primary activities in accounts receivable management,
first is establishing credit terms granting credit
to various customers and then processing transactions.
You need to understand that a company can offer multiple
credit terms, examples of credit terms would be
2/10 net 45. This means that a company is saying that customers
need to pay back within 45 days. But the customer
will get a 2% credit... but the customer will get a 2%
discount if he pays within 10 days. Now tell me what
1/10 net 30 means? This means that if a customer pays
within 10 days, he will get a 1% discount, but the
customer is supposed to pay the entire amount within
30 days. You can also have payment terms such as cash
on delivery or cash before delivery. So there are
a lot of credit terms that can be defined. A company
needs to establish which customer has which credit
terms. Obviously customers that have a good credit record
or are very credit-worthy can get more relaxed credit
terms whereas a customer who does not have good
credit would have to essentially pay cash on delivery
or we could say that in that case the company would
offer customers very tight credit terms. The second
primary activity is monitoring the credit balances
and finally we need to measure the performance of
our credit function. As you might imagine there is
a trade-off between strict credit terms and ability
to make sales. If a company has very strict credit
terms relative to competitors then a company will
lose sales because customers would rather go to
your competitor who offers easier or looser credit terms.
On the other hand if your credit terms are too lenient
than customers might take advantage of those credit
terms, but your bad debt allowance might have to
go up, in other words customers who don't have a strong
credit history or customers who don't have a strong
financial position will buy goods from you on credit
but not be able to pay up on time. You need to understand
at a high-level how companies manage customer
receipts. The curriculum says a lot on this but this
item is not emphasized in the learning objectives.
So I'll just give you some high-level points. You are
a company, your customers make payments. What
are the different ways in which they can make payments?
Perhaps the best way to make payments is using electronic
funds transfer where money is transferred electronically
from the customer's account to your company's account.
Lockbox, this is another mechanism where customers
mail their checks to a post office box. And your bank
is responsible for picking up the checks from the
post office box and depositing in the account. There
is a measure called the float factor, which essentially
measures check deposits; float factor is equal to
average daily float / average daily deposits. The
float in this context refers to money that is in transit,
money that has left the customer's account and hasn't
yet hit your company's account. A high float factor
implies that there is a lot of money in transition.
How do we evaluate receivables management? From
an exam perspective, this is important because you
as an analyst will be evaluating among several other
things how well a company manages its receivables.
There are many ways of measuring accounts receivable
performance, most deal with how effectively outstanding
receivables can be converted into cash. In other
words how good is a company at collecting money
from its customers. A simple measure which we have talked about earlier is the number of days of receivables.
If you recall we calculated the receivables turnover
ratio, which was simply equal to sales or credit
sales divided by average receivables. And then
we calculated the days of receivables by saying
that we take the number of days in a period if we are taking a
one year period then we have 365 / receivables turnover. This
is a simple measure and perhaps the measure that
is most likely to show up on your exam. But the problem
with the measure is that it does not consider the
age distribution. You might have a company where
you have accounts receivables that are between
let's say 50% of the receivables are between 30
and 60 days old and the remaining 50% are greater than
90 days. This is a very simple example
of an aging schedule. This simplistic measure does
not consider the aging schedule. So let us look at
a slightly more sophisticated example, where we do consider
the age distribution. Here is an example of an age distribution
for receivables. Receivables in the month of January that are
less than 31 days old or less than 31 days outstanding
equals 2000, between 31 days to 60 days outstanding
is 1500 and so on. Obviously, the longer that a receivable
is outstanding the most dangerous it is for a company
because the chances of this money being collected
are relatively low. We also have the data for February
and March. In this table, we have taken the January
numbers and expressed them as a percent. The 40% is
equal to 2000 / this entire amount. If you add up all
these numbers you have 5,000; 2,000 is 40% of 5000. Similarly
1500 represents 30% and so on. What we are after
is calculating the weighted average collection period
for every month. For January, that number is 46.5
and this is how we come up with the number. This information
is going to be given to you. For receivables that are
less than 31 days outstanding we are told that on
average the receivables are 15 days outstanding. This
number will be given to you if you get a question
on the exam. In the 31 to 60-day category, you are given
this information that the receivables are on average
45 days old. In the real world, you can think of this
information coming from the MIS system of a company.
The 40%, 30% numbers were calculated right here for
the month of January. You multiply the average collection days,
15 times the weight 40% to come up with 6. do this for each
row and then add up all these numbers and you will
get 46.5. So 46.5 is the weighted average collection period
which does take into account the age distribution
of the receivables. This in other words is a more
sophisticated measure compared to days of receivables.