Friday, March 15, 2013

Teaching Note on Accounts Payable Management



The very idea of ‘accounts payable’ depends on the ‘(business is a) going concern’ concept of accounting. Accounts payable are the amounts due to suppliers of goods and services that have not yet been paid. These are important short term sources of finance, they are usually referred as ‘spontaneous’ or ‘self adjusting’ sources of finance. As long as business remains as a going concern, volume of accounts payable depends on the level of firm’s operations. Accounts payable policy of a firm also depends on accounts receivable policy of the supplier. In other words accounts payable are the other side of the account receivables’ coin. Accounts payable predominantly include trade credit and accrual expenses.
Trade credit
Trade credit refers to credit that a buyer firm gets from the suppliers of goods in the normal course of its operations. It is a dominant part of accounts payable. It appears as ‘sundry creditors’ on the Indian firms’ balance sheets. Trade credit is a cheaper source of short term finance than the institutional agencies. It is because suppliers, having better information and control over buyer than the institutional agencies offer better terms in extending the trade credit.
The advantages of trade credit are as follows:

·         Easy availability: In most of the cases (except financially distressed firms), trade credit is automatic and does not require any negotiations.
·         Flexibility: As mentioned earlier, the amount of trade credit is positively associated with the level of firm’s operations. It increases (decreases) with the increase (decline) in firm’s sales.
·         Informality: Trade credit is a spontaneous source of finance, does not require any formal agreement.

Trade credit seems to be cost free as it does not involve any explicit interest charges. But it involves implicit cost. Extending trade credit is nothing but financing buyer purchases; it involves costs to the supplier. Such costs of trade credit may be transferred to the buyer firm by increased price of goods / services. However, the extent of such a transfer depends on the bargaining power of supplier and buyer in the market.

Accrual expenses
            Accrual expenses represent the liability that a firm has to pay for the services, which it has received. They include accrued wages, salaries, taxes and interest payments, etc.

Managing Accounts Payable
            Terms of the trade credit usually includes cash discounts, say ‘2/10, net 30’. It implies that 2% discount if paid within 10 days (or) full payment by the end of the credit period i.e., 30 days. Here the buyer firm’s financial manager has to take the policy decision whether to avail the cash discount or not. If the financial manager takes the discount, it benefits the firm in terms of less cash outflow, but the firm foregoes the credit granted by the supplier beyond the discount period. If the manager does not take discount, he avails credit for the extended period but pays more. It means buyer firm incurs opportunity costs when it does not avail cash discount.
The cost of credit (implicit cost) during the discount period is zero. It will be beneficial for the firm to pay at the end of the discount period. Once the discount period ends the cost of credit suits up and declines as the credit period ends. For example, if the terms are ‘2/10, net 30’. The cost of trade credit is 73.47% if the credit is paid on the 20th day. It will be 36.74% if it is paid on the last day of the credit period i.e. 30th day. So the firm will be advantageous to pay the credit on the last day of the credit period, if it does not avail the cash discount. However, the financial manager’s decision of availing cash discount depends on his firm’s cost of short-term borrowing. If the buyer firm’s cost of short term borrowing is greater than the minimum cost of credit on any day during the credit period, the firm should not avail the cash discount and make the payment on the day when cost of trade credit is minimum (i.e., on the last day of the credit period).


Stretching accounts payable
            It refers to the delaying of payment beyond the due date. Such a delay minimizes the net present value (NPV) of accounts payable disbursement. That is, longer the time for payment, lower is the NPV of payment disbursement and higher the value of the firm. It incentivizes the financial managers to stretch the accounts payable and avail the increase in positive float. Though stretching accounts payable benefits firm, it also imposes costs on the firm. These are penalty for delayed payment and other indirect costs. Indirect costs include erosion of goodwill, poor credit rating and declining credit availability. NPV of accounts payable disbursement depends on firm’s opportunity cost of capital, time delayed, and penalty for delayed payment.
            Where V = value of the order; Penalty = delayed payment calculated on Rs 1; t_s= number of days payment is stretched; and K= daily opportunity cost of the firm on Rs 1.
            Financial manager of the buyer firm is incentivized to stretch the payment disbursement as long as possible without hurting the firm’s interests. Though arithmetic calculation doesn’t consider indirect costs, they are important for the firm’s long term future. Hence, the financial manager is expected to make calculated move to increase the value of firm by appropriately stretching the accounts payable disbursement.

Evaluating Accounts Payable Management
Number of days payable is a useful measure for evaluating firms’ accounts payable management policies. The mere number of days payable will not help in making relative comments over the firm’s policy. Ideally, firm’s number of days payable is compared to its industry peer. The firm with more number of days payable is referred as having better credit terms. However, considering the other credit terms under which the credit is extended to the firm is very important. Larger number of days payable can also be conceived negatively about the firm’s financial health.

Note: The discussion would be effective in the class, if one includes the small cases at various stages of this lecture. For the appropriate case problems, please write to me, i am happy to share!
Bibliography:
Hrishikesh Bhattacharya (2001), “Working Capital Management: Strategies and Techniques”, Prentice-Hall of India Private Limited, New Delhi.
Pandey I M (2003), “Financial Management” Vikas Publishing House Pvt Ltd, New Delhi.
Edgar A Norton, Jr., Kenneth L. Parkinson, and Pamela Peterson Drake (2011), “Working Capital Management” in CFA program curriculum -2011, Pearson Learning Solutions.

Wednesday, January 4, 2012

Indian firms by their ownership

The table below displays the classification of Indian firms based on their ownership as on 3rd January 2012. CMIE-Prowess database has been the source. Stand-alone firms include those firms classified in the database as 'private Indian' and 'private foreign'. Government controlled firms include all those that are classified as central, joint and state government enterprises. We exclude co-operative sector firms (less than 0.2% of total number) and small & ancillary units (defined by Govt of India).


Percentage share

Market capitalization
Number of firms (including unlisted firms)
Business group affiliated firms
57.50%
30.46%
Stand-alone firms
15.37%
63.46%
Government controlled firms
27.13%
6.07%

Tuesday, March 8, 2011

Damodaran's view on Buffett's view of derivatives!!

Here i go... With the basic understanding of Black-Scholes' option pricing model which under value deep out of the money options and over values the options that are illiquid (as the pricing model assumes continuous prices); (Of course Damodaran too mentions the same), Prof presented a detailed critic of Buffett's recent statement that 'Black-Scholes wildly produces inappropriate values when applied to long-dated-options.

This illustration clarifies many nitty-gritties of B-S option pricing model! [Link]

Saturday, March 5, 2011

Damodarn on Equity risk premium!

[Link] Damodaran discusses on forward risk premium. Actually it is quite simple and you can have daily risk premium which reflects the current risk market experiences. The knowledge of which is very helpful for the fund manager. It is simple, calculated the today's return on security, by using the corresponding risk free rate, back out the risk premium!!

Of course, incorporating the everyday's risk and making the appropriate changes in the portfolio may be ideal, but it causes huge transaction costs. However, the knowledge of the same is helpful!!

Sunday, February 27, 2011

Thursday, February 17, 2011

Does the exchange business stink??

Jeff Carter speaks about why valuations are cheap in the case of few exchanges when compared to their other counterparts? He says the exchange regulations influences their valuation! [Link]

Tuesday, February 15, 2011

Meaningless 'Hatred' towards China!!

I blame electronic and print media at the first place and our irrational political leaders (here 'our' i mean all leaders except from China) at the second for cultivating 'hatred' towards China and its Success stories. There are thousands of columns on print media and millions of articles on electronic media, that casts doubts over the sustainability of Chinese growth momentum. Innumerable of them held high India's growth story higher than Chinese, though India don't match China on any parameter. China sustainably managing its double digit growth and highest position on global trade. Now, China is successfully (so far) pursuing to achieve the world 'reserve currency' status to its own. Here are the views of Indian notable economist (a great Philosopher too) Amartya Sen. [Link]

Monday, February 14, 2011

Yuan as potential 'global currency'

It is a dream, Chinese leadership wants to make it true! China is known for rigorous in pursuing the set objectives. It has almost achieved the objective of having 50% external transactions to be invoiced in Yuan. As it is a major player in global trade, Yuan already found its visibility. Moreover, its steadiness and constant fluctuations are making it to be pursued as the global reserve currency. Here is a nice write up from business standard. [Link

Friday, February 11, 2011

Deals and Deals, Exchanges are getting integrated!! How about us??

As Prof. Verma said (in his blog), it looks like mighty Atlantic Ocean no longer exists. Most of the Europe had already aligned with North America through NYSE Euronext (through a deal that struck during early 2000s), now everything goes as expected (LSE acquiring TMX, NYSE Euronext - Deutsche Boerse AG deal) in another one year or two the initial statement will be true. On the other side, Indian Ocean is also expected to lose its existence soon with the SGX-ASX deal, though currently deal is facing few legal and regulatory hurdles. If i understand correctly, down the line around 5 years into the future, there will be 4 or 5 exchanges (borrowed idea from Jeff Carter) world over and their branches in all the countries. That will be a true heaven for an investor who can buy or sell any international equity security without much hurdle.

As the world is moving very fast, though we have world class exchange and depository infrastructure, we are virtually split and pondering on who has to own exchanges? Whether to allow them to list or not? Our policy is lagging behind and now struck at a road block!

My vote is for allowing the exchanges to list and increase the competition by providing level playing field for all the exchanges and allow them to merge with international exchanges...............SEBI should regulate them and direct them to provide best services to small investors........ let allow and give free hand to market to get best services!!

Thursday, February 10, 2011

Corruption drags down the VALUE OF FIRM!

So far 'level of corruption' in a country has not been considered exclusively in valuing a firm, rather it has been viewed as part of the country risk. Even, so far 'corruption' has been viewed as ethical issue and has been treated only on moral grounds. Its exclusive impact has never been factored in the valuation as we have not concretely realized its economic consequences. However, the corruption within the firm has been the prominent issue in terms of its implications to 'corporate governance'.

Recently in a study by Prof. Lee from Standford Graduate School of Business, provided the evidence that level of corruption in a country significantly influences the firms' valuation within that economy. Firms in the countries with high level of corruption tend to be valued at low when compared to their counterparts in other countries where the level of corruption is low. I feel it is a serious issue for the investing community to factor in 'level of corruption' or assign more weight to it in the variable which measures country level risk. As market expected to value low, entrepreneurs need to reconsider their plans to start their businesses in the corruption ridden countries.

Though further research is required to consider the gravity of issue, it seems the countries and even the citizens have plain incentives to fight for corruption free world!

Here is the link to the original paper. [Link]


Macro economics as kitchen sink!!

I always find confusing (rather gets confused by self-proclaimed economists..............i believe every rational human being is an economist) to distinguish the schools of thought especially in macro economics. This is particularly so in the case of Neo-Keynesian and New Keynesian thoughts. Karl Smith (Professor, University of North Carolina) made a nice attempt and drew a flow chart. [LINK]

Wednesday, February 9, 2011

Covered call strategy explained!

It is a derivative trading strategy. It essentially means that you own a stock and sell call on the stock you owned and collect the premium. This strategy make sense if one wants to keep hold on the stock and thinks that in the short run its price will be either stable or slightly goes down........... but sure that its long term prospects are good. The strategy has been nicely explained by a finance professor. Here is the [link]!!