Short-Term Finance and Planning

1. Short-Term Finance and Planning Chapter 26

2. Key Concepts and Skills • Understand the components of the cash cycle and why it is important • Understand the pros and cons of the various short-term financing policies • Be able to prepare a cash budget • Understand the various options for short-term financing

3. Balance Sheet Model of the Firm Current Liabilities Current Assets Net Working Capital Long-Term Debt Fixed Assets 1. Tangible 2. Intangible Shareholders’ Equity

4. Short-Term Finance and Planning • What is a reasonable level of cash to keep on hand (in a bank) to pay bills? • How much should the firm borrow in the short term? • How much credit should be extended to customers?

5. 26.1 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

6. Long-Term Debt Net Working Capital Fixed Assets + = + Equity Other Current Assets Net Working Capital Current Liabilities = Cash + – Defining Cash in Terms of Other Elements Cash = Long-term debt + Equity + Current liabilities − Current assets other than cash − Fixed assets

7. Activities That Increase Cash (sources of cash) • Increasing long-term debt (borrowing over the long term) • Increasing equity (selling some stock) • Increasing current liabilities (getting a 90-day loan) • Decreasing current assets other than cash (selling some inventory for cash) • Decreasing fixed assets (selling some property)

8. Activities That Decrease Cash (uses of cash) • Decreasing long-term debt (paying off a long-term debt) • Decreasing equity (repurchasing some stock) • Decreasing current liabilities (paying off a 90-day loan) • Increasing current assets other than cash (buying some inventory for cash) • Increasing fixed assets (buying some property)

9. Example • If accounts payable go up by $100, does this indicate a source or a use? What if accounts receivable go up by $100?

10. Example • Accounts payable are what we owe our suppliers. This is a short-term debt. If it rises by $100, we have effectively borrowed the money, which is a source of cash. • Receivables are what our customers owe to us, so an increase of $100 in accounts receivable means that we have loaned the money; this is a use of cash.

11. 26.2 The Operating Cycle and the Cash Cycle

12. The Operating Cycle and the Cash Cycle Example • One day, call it Day 0, we purchase $1,000 worth of inventory on credit. We pay the bill 30 days later, and, after 30 more days, someone buys the $1,000 in inventory for $1,400. Our buyer does not actually pay for another 45 days. 

13. The Operating Cycle and the Cash Cycle Example

14. The Operating Cycle and the Cash Cycle Example

15. The Operating Cycle and the Cash Cycle Example

16. Accounts payable period Cash cycle = Operating cycle – 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, respectively.

17. The Operating Cycle and the Cash Cycle • Operating cycle: from the time we acquire some inventory to the time we collect the cash. • Cash cycle: the number of days that pass between when we collect the cash from a sale and when we actually pay for the inventory. 

18. Raw material purchased Order Placed Stock Arrives Inventory period Accounts receivable period Cash cycle The Operating Cycle and the Cash Cycle Cash received Finished goods sold Time Accounts payable period Firm receives invoice Cash paid for materials Operating cycle

19. Example • 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

20. Example • 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 = 111.3 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 = 57.1 days • Operating cycle = 111.3 + 57.1 = 168.4 days

21. Example • 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 = 38.9 days • Cash Cycle = 168.4 – 38.9 = 129.5 days • We have to finance our inventory for 129.5 days.

22. Example 2 • You have collected the following information for the Slowpay Company: • Credit sales for the year just ended were $50,000, and cost of goods sold was $30,000. How long does it take Slowpay to collect on its receivables? How long does merchandise stay around before it is sold? How long does Slowpay take to pay its bills? Find the operating cycle and cash cycle.

23. Example 2 • Operating cycle : 73 + 14.6 = 87.6 days • Cash cycle: 87.6 − 45.6 = 42 days

24. 26.3 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

25. 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)

26. Size of Investment in Current Assets • Carrying costs:  Costs that rise with the level of investment in current assets • Opportunity Cost • Cost of maintaining the economic value • Shortage costs: Costs that fall with increases in the level of investment in current assets • Trading, or order, costs • Costs related to safety reserves

27. Minimum point Shortage costs CA* Carrying Costs and Shortage Costs Total costs of holding current assets. $ Carrying costs Investment in Current Assets ($)

28. 26.4 Cash Budgeting • 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

29. 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 • Accounts payable • Purchases = 50% of next quarter’s sales • Beginning payables = 125 • 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

30. Example • 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.

31. Example • 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.

32. Example • half of the purchases will be paid for each quarter, and the remaining will be paid the following quarter. • Beginning payables = $125

33. Example • half of the purchases will be paid for each quarter, and the remaining will be paid the following quarter. • Beginning payables = $125

34. Example • half of the purchases will be paid for each quarter, and the remaining will be paid the following quarter. • Beginning payables = $125

35. Example

36. Example

37. 26.5 The Short-Term Financial Plan • 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) • Secured Loans • Accounts receivable can be either assigned or factored. • Inventory loans use inventory as collateral. • Other Sources • Banker’s acceptance • Commercial paper

38. Summary • 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?