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SHORT-TERM FINANCE AND PLANNING

Chapter 18

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18-2

KEY CONCEPTS AND SKILLS

• Describe the components of the cash cycle and why it is important

• Define the pros and cons of the various short-term financing policies

• Prepare a cash budget• Outline the various options for short-term

financing

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CHAPTER OUTLINE

18.1 Tracing Cash and Net Working Capital18.2 The Operating Cycle and the Cash

Cycle18.3 Some Aspects of Short-Term Financial

Policy18.4 The Cash Budget18.5 Short-Term Borrowing18.6 A Short-Term Financial Plan

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BALANCE SHEET MODEL OF THE FIRM

How much short-term cash flow does a company need to pay its bills?

Net Working Capital

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt

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18.1 TRACING CASH AND NET WORKING CAPITAL

• Current Assets are cash and other assets that are expected to be converted to cash within the year.• Cash• Marketable securities• Accounts receivable• Inventory

• Current Liabilities are obligations that are expected to require cash payment within the year.• Accounts payable• Accrued wages• Taxes

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DEFINING CASH IN TERMS OF OTHER ELEMENTS

Net Working Capital

+Fixed Assets

=Long-Term Debt

+ Equity

Net Working Capital

= CashOther

Current Assets

Current Liabilities

–+

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DEFINING CASH IN TERMS OF OTHER ELEMENTS

• An increase in long-term debt and or equity leads to an increase in cash—as does a decrease in fixed assets or a decrease in the non-cash components of net working capital.• The sources and uses of cash follow from this

reasoning.

Cash =Long-Term Debt

+ Equity –Net Working

Capital (excluding cash)

Fixed Assets

–

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ACTIVITIES THAT INCREASE AND DECREASE CASH

Increase Cash

• Increase Long Term Debt• Sell Additional Equity• Increase Current

Liabilities• Sell Current Assets• Sell Fixed Assets

Decrease Cash

• Pay off Long Term Debt• Repurchase Equity• Pay off Current

Liabilities• Buy Current Assets• Buy Fixed Assets

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18.2 THE OPERATING CYCLE AND THE CASH CYCLE

TimeAccounts payable period

Cash cycle

Operating cycle

Cash received

Accounts receivable periodInventory period

Finished goods sold

Firm receives invoice Cash paid for materials

Order Placed

Stock Arrives

Raw material purchased

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THE OPERATING CYCLE AND THE CASH CYCLE

• In practice, the inventory period, the accounts receivable period, and the accounts payable period are measured by days in inventory, days in receivables, and days in payables.

Cash cycle = Operating cycle –Accounts payable period

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EXAMPLE: OPERATING AND CASH CYCLE FACTS

• Inventory:• Beginning = 200,000• Ending = 300,000

• Accounts Receivable:• Beginning = 160,000• Ending = 200,000

• Accounts Payable:• Beginning = 75,000• Ending = 100,000

• Net sales = 1,150,000• Cost of Goods sold = 820,000

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EXAMPLE: OPERATING CYCLE CALCULATIONS

• Inventory period• Average inventory = (200,000+300,000)/2 =

250,000• Inventory turnover = 820,000 / 250,000 = 3.28

times• Inventory period = 365 / 3.28 = 111 days

• Receivables period• Average receivables = (160,000+200,000)/2 =

180,000• Receivables turnover = 1,150,000 / 180,000 =

6.39 times• Receivables period = 365 / 6.39 = 57 days

• Operating cycle = 111 + 57 = 168 days

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EXAMPLE: CASH CYCLE CALCULATIONS

• Payables Period• Average payables = (75,000+100,000)/2 = 87,500• Payables turnover = 820,000 / 87,500 = 9.37 times• Payables period = 365 / 9.37 = 39 days

• Cash Cycle = 168 – 39 = 129 days• We have to finance our inventory for 129

days.• If we want to reduce our financing needs, we

need to look carefully at our receivables and inventory periods – they both seem excessive.

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INTERPRETATION OF THE CASH CYCLE

• Cash cycle increases when:• Inventory and receivable periods get longer

• Cash cycle decreases when:• Payables periods are extended and receivables periods

shortened

• There is a direct connection between a company’s cash cycle and profitability• Total asset turnover is a useful measure

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18.3 SOME ASPECTS OF SHORT-TERM FINANCIAL POLICY

• There are two elements of the policy that a firm adopts for short-term finance.• The size of the firm’s investment in current

assets, usually measured relative to the firm’s level of total operating revenues.• Flexible • Restrictive

• Alternative financing policies for current assets, usually measured as the proportion of short-term debt to long-term debt.• Flexible • Restrictive

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SIZE OF INVESTMENT IN CURRENT ASSETS

• A flexible short-term finance policy would maintain a high ratio of current assets to sales.• Keeping large cash balances and investments in

marketable securities• Large investments in inventory• Liberal credit terms

• A restrictive short-term finance policy would maintain a low ratio of current assets to sales.• Keeping low cash balances, no investment in marketable

securities• Making small investments in inventory• Allowing no credit sales (thus no accounts receivable)

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CARRYING COSTS AND SHORTAGE COSTS

$

Investment in Current Assets ($)

Shortage costs

Carrying costs

Total costs of holding current assets.

CA*

Minimum point

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APPROPRIATE FLEXIBLE POLICY

$

Investment in Current Assets ($)

Shortage costs

Carrying costs

Total costs of holding current assets.

CA*

Minimum point

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APPROPRIATE RESTRICTIVE POLICY

$

Investment in Current Assets ($)

Shortage costs

Carrying costs

Total costs of holding current assets.

CA*

Minimum point

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ALTERNATIVE FINANCING POLICIES

• A flexible short-term finance policy means a low proportion of short-term debt relative to long-term financing.• A restrictive short-term finance policy means

a high proportion of short-term debt relative to long-term financing.• Compromise policy meets restrictive and

flexible policies in the middle.• In an ideal world, short-term assets are

always financed with short-term debt, and long-term assets are always financed with long-term debt.• In this world, net working capital is zero.

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18.4 THE CASH BUDGET

• A cash budget is a primary tool of short-run financial planning.• The idea is simple: Record the estimates

of cash receipts and disbursements. • Cash Receipts• Arise from sales, but we need to estimate

when we actually collect• Cash Outflow • Payments of Accounts Payable• Wages, Taxes, and other Expenses• Capital Expenditures• Long-Term Financial Planning

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EXAMPLE• Pet Treats Inc. specializes in gourmet pet treats and

receives all income from sales• Sales estimates (in millions)

• Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550• Accounts receivable

• Beginning receivables = $250• Average collection period = 30 days

• Accounts payable• Purchases = 50% of next quarter’s sales• Beginning payables = 125• Accounts payable period is 45 days

• Other expenses• Wages, taxes and other expense are 30% of sales• Interest and dividend payments are $50• A major capital expenditure of $200 is expected in the second

quarter• The initial cash balance is $80 and the company maintains

a minimum balance of $50

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EXAMPLE: CASH INFLOWS• ACP = 30 days, this implies that 2/3 of sales are

collected in the quarter made, and the remaining 1/3 are collected the following quarter.

• Beginning receivables of $250 will be collected in the first quarter.

Q1 Q2 Q3 Q4

Beginning Receivables 250 167 200 217

Sales 500 600 650 800

Cash Collections 583 567 633 750

Ending Receivables 167 200 217 267

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EXAMPLE: CASH OUTFLOWS• Payables period is 45 days, so half of the purchases will be paid for

each quarter, and the remaining will be paid the following quarter.• Beginning payables = $125

Q1 Q2 Q3 Q4

Payment of accounts 275 313 362 338

Wages, taxes and other expenses 150 180 195 240

Capital expenditures 200

Interest and dividend payments 50 50 50 50

Total cash disbursements 475 743 607 628

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EXAMPLE: CASH BUDGET

Q1 Q2 Q3 Q4Total cash collections 583 567 633 750

Total cash disbursements 475 743 607 628

Net cash inflow 108 -176 26 122

Beginning Cash Balance 80 188 12 38

Ending cash balance 188 12 38 160

Minimum cash balance -50 -50 -50 -50

Cumulative surplus (deficit) 138 -38 -12 110

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18.5 SHORT-TERM BORROWING

• The most common way to finance a temporary cash deficit is to arrange a short-term loan.• Unsecured Loans• Line of credit (at the bank)• Compensating balances

• Secured Loans• Accounts receivable can be either assigned or

factored.• Inventory loans use inventory as collateral.

• Commercial Paper• Trade Credit• Cash Discounts

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QUICK QUIZ

• How do you compute the operating cycle and the cash cycle?

• What are the differences between a flexible short-term financing policy and a restrictive one? What are the pros and cons of each?

• What are the key components of a cash budget?• What are the major forms of short-term

borrowing?