PLETHORA

Teaching Note on Accounts Payable Management

2013-03-15T11:35:00.003+05:30

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 20^th day. It will be 36.74% if it is paid on the last day of the credit period i.e. 30^th 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.

Indian firms by their ownership

2012-01-04T12:48:00.000+05:30

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%

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

2011-03-08T12:51:00.000+05:30

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]

Damodarn on Equity risk premium!

2011-03-05T23:02:00.000+05:30

[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!!

Berkshire Hathaway's 2010 Financials

2011-02-27T09:53:00.000+05:30

Prof. David Kass analyzes BH's financials-2010. [Link], [Link].

(Sorry for the long absence on the blog sphere)

Does the exchange business stink??

2011-02-17T21:54:00.000+05:30

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]

Meaningless 'Hatred' towards China!!

2011-02-15T10:05:00.000+05:30

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]

Yuan as potential 'global currency'

2011-02-14T12:15:00.000+05:30

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]

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

2011-02-11T20:40:00.001+05:30

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!!

Corruption drags down the VALUE OF FIRM!

2011-02-10T12:00:00.000+05:30

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!!

2011-02-10T10:18:00.000+05:30

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]

Covered call strategy explained!

2011-02-09T09:43:00.000+05:30

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]!!

Research In Indian B-Schools

2011-02-08T10:26:00.000+05:30

Link As clearly discussed in the article, Research in B-School should focus on case development. Ideally, case development should have the priority over the academic research and practitioner oriented research, especially in B-Schools. Unfortunately, in practice focus is being given to academic research which always lacks the practical applicability, it is mostly true in Indian B-schools. The prominent reason i can think of for such a phenomenon is lack of profession experience to the faculty. Being a professional course, MBA is expected to give practical orientation to the students, for that the faculty should have the practical work experience in the concerned field they teach in the class room. The severe shortage of faculty in the country, the B-Schools are being forced to recruit the candidates who just passed out from universities with their doctorates. These fresh doctorates neither have exposure to practical world nor practical work experience. The shortage of management faculty has arosen with innumerable B-schools without adequate faculty and infrastructure.

Lack of proper planning for the future educational needs is the core issues that had never been the subject of concern for the policy makers.!! As long as it is not served............problem keeps aggravating!

Islamic finance and its foot prints in India

2011-02-07T16:40:00.000+05:30

[Link] It is nicely and briefly written piece. The piece favors rather argues for the separate legislation to promote the Islamic finance, the form of finance recognized under the principles of Sharia law. As we are enjoying the well regulated services from the financial system, do we really need a separate stream of finance. Can we really tap additional funds which we couldn't through current system, through Islamic financial system? Does it really worth to embark on additional system as it expected to cause further regulatory confusion? Doesn't it further deepen and broaden the religious differences?

My main question is that does our formal (current) system really has gaps? Is it really leaving behind any potential resources (funds)? Probably i need to further probe the issue!!

An elegant discussion on Sampling!

2011-02-07T12:36:00.001+05:30

Aswath Damodaran has an interesting piece [Link] general sampling issues and he elegantly explains the potential issues with the contextual example of US unemployment figures. By the way he explains how the unemployment figures are computed (focus on US).

Why economists failed in predicting the crisis?? .... Cont'd!

2011-02-07T12:06:00.000+05:30

Ajay Shah in his blog discussed at length on the same issues and on Prof. Rajan's argument [Link]. I remind you that i did blog yesterday on the same.

Why economists failed in predicting the crisis??

2011-02-06T10:33:00.000+05:30

This questions has been popular, after it has been coined by the Queen of England, when it has been posed at a conference at London school of economics. There have been a several explanation why the economists failed to spot the crisis.......one group argues the we simply don't have models, another argues that the economists blindly believed the free market and irrationally assumed that the market participants are rational........ there were also argument that attributed the reason to 'sponsored research'............most of the research is sponsored which is tend to be biased towards the sponsoring party (mostly financial market participants)....................Prof. Rajan in his official blog Fault Lines argues that since most of the research is carried out through sponsorship from the industry................and realistically there expected to be reasonable amount of bias...............there should be disclosure about the 'sponsorship'............ so that the market interprets accordingly and take into account the potential bias in the findings...........................Possibly such known information about the bias before the research, the researcher (economist) tend to be more accurate and ......it essentially eliminates any such bias!!

Find the Prof. Rajan's take on the issue on his blog! [Link]

Growth through austerity!??

2011-02-05T23:28:00.001+05:30

Is the growth possible through austerity? Post-crisis the word 'austerity' has become popular. But the question of whether it helps the countries to come out of recession? Does it help to reduce fiscal deficit? It certainly seems rational that fiscal deficit can potentially be reduced if the democratic government keeps a check on wasteful expenses. But reducing consumption will not contribute to the growth of economies..... moreover it leads to contraction. Here i mean consumption not just by government but also the citizens. It will potentially reduce the aggregate demand causing further deceleration! UK's case is the ready example. UK embraced the austerity drive to stimulate the growth process and reduce the fiscal deficit............. it scored very poorly in the growth front which is crucial. Though it brought down the fiscal deficit holistically............ but it really caused the further contraction!!

The economist carries an interesting piece. [Link]

Lottaries are demistified!!

2011-02-05T12:02:00.000+05:30

Are the lotteries as tax on dumb people? Here is a great story (Which Ajay Shah also shared) who a statistician unfolded the math behind these lotteries. [Link]

Note: This link might have filtered as it has word 'lottery' which comes under the 'gambling' ....... u see most of the web filtering guards are hypocractic!!

Market indices explained!!

2011-02-04T21:14:00.000+05:30

Why market indices are important? We all know that market index is some sort of average of its constituents and it reflects the overall market movement. And they are generally used to gauge the direction of economy, overall economic activity, they are also used to measure the performance of various mutual fund schemes as the benchmark performance. These market indices may be classified into price weighted, value/market weighted and equal weighted indices. The following video link explains how they are constructed? how the return on such indices are calculated? and what happens when there is change in the magnitude of the constituents? [LINK]

Readers who undergone the 'Investments' course, may use this talk as refreshing......otherwise it is very educating!!

Interesting Links-20 (04/02/2011)

2011-02-04T10:51:00.000+05:30

Markets:
New SEBI initiatives:
a) Planning to introduce call auctions in the proposed SME Bourse.[Link] The idea of setting up of separate bourse for the SME (less than Rs 25 crore) has been coined by SEBI in the mid of 2009. It will soon be implemented. As we all know, that these SME stocks trade very infrequently on the bourses. To correct it and encourage more trade to happen SEBI is mulling over to implement continuous call auctions (each running for 15 minutes) all along the trading hours.
b) 'Ring Fence' to prevent flash crashes [Link]. It is still in our memory, during the last may (2010) Dow dropped by 700 points without any major news purely due to some technical snag at the HFT desk of a prominent investment bank. At that time, (not on same day) some miss trading caused the plunge in RIL scrip on Indian bourses. These flash crashes generally occurs when the large market order interacts with a thin order book. These large market order influence the price, the effect of which will be multi-fold as it feeds into automated trading systems (HFT).

Macro Economy
An interesting piece on the impact of monetary policy in Business line. [Link]

Interesting Links-19 (03/02/2011)

2011-02-03T10:07:00.001+05:30

Corporate Finance:
Corporate governance mechanism's objectives are being redefined. As per the Anglo Saxon method of corporations, the shareholders are the key stakeholders and the managers who look after the firm should work for the maximization of shareholders' wealth. And managers contracts and their incentive mechanisms are designed such that their welfare is aligned with that of the shareholders. The benefits of other stakeholders are limited to the transactions they are involved in. The recent crisis brought in the government in particular and society in general on to the board as the prominent stakeholder in corporations. Now the definition of corporate governance is undergoing rapid changes in terms of its objectives.......... time has come it has to look beyond the welfare of shareholders. Here is a nice write up. [Link]

World economy:

Jonathan Parker, Kellog school of Management reports the initial reactions on the report of global financial crisis. (U might remember, i posted a link to it under the title of Official book on finance crisis) [Link]

Yield curve shape as the macro economic indicator!!

2011-02-02T21:20:00.000+05:30

What do we know about the yield curve? what does it shape mean to the investors and to general economy. Here is a nice post from a finance professor. [Link]

Can the Yield curve predict the future economic scenario? Does the economy tank following the inverted yield curve? What is that evidence speaking? This post is very interesting. [Link]

Fifteen Facts about 'India'!!

2011-02-02T16:11:00.000+05:30

25% of the world new workforce will be Indians (by 2014) and average Indian age seems to be 20 years less than that of Japanese (26 Vs 25) (sadly i am already older than average Indian :( :( ). These stats seems to be good facts, but the worst is that 42% of the world poor lives in India!! Click on this link for the remaining facts!! [Link]

Market over reaction or under reaction!!

2011-02-02T14:27:00.000+05:30

It is widely reported and seems to be true that the positive news benefit 'worst' stocks (with low PE and reported earnings below the expectations) significantly far better than 'best' stocks!! Forbes India carries a nice illustration [Link]