Short-Term Finance and Planning

1. Chapter 18 Short-Term Finance and Planning

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. 18.1 Tracing Cash and Net Working Capital 18.2 The Operating Cycle and the Cash Cycle 18.3 Some Aspects of Short-Term Financial Policy 18.4 The Cash Budget 18.5 Short-Term Borrowing 18.6 A Short-Term Financial Plan Chapter Outline

4. Balance Sheet Model of the Firm Current Liabilities Current Assets Net Working Capital Long-Term Debt How much short-term cash flow does a company need to pay its bills? Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity

5. 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

6. Long-Term Debt Net Working Capital Fixed Assets + = + Equity Other Current Assets Net Working Capital Current Liabilities = Cash + – Long-Term Debt Net Working Capital (excluding cash) Fixed Assets Cash = + Equity – – Defining Cash in Terms of Other Elements

7. Long-Term Debt Net Working Capital (excluding cash) Fixed Assets Cash = + Equity – – 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.

8. Raw material purchased Order Placed Stock Arrives Inventory period Accounts receivable period Cash cycle 18.2 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

9. 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.

10. 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

11. 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 = 112 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 = 112 + 57 = 169 days

12. 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 = 39 days • Cash Cycle = 169 – 39 = 130 days • We have to finance our inventory for 130 days. • If we want to reduce our financing needs, we need to look carefully at our receivables and inventory periods – they both seem excessive.

13. 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

14. 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)

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

16. Minimum point Shortage costs CA* Appropriate Flexible Policy $ Carrying costs Total costs of holding current assets. Investment in Current Assets ($)

17. Minimum point Shortage costs CA* Appropriate Restrictive Policy $ Total costs of holding current assets. Carrying costs Investment in Current Assets ($)

18. 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. • 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.

19. 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

20. 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

21. Example • 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.

22. Example • 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

23. Example

24. 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) • Secured Loans • Accounts receivable can be either assigned or factored. • Inventory loans use inventory as collateral. • Other Sources • Banker’s acceptance • Commercial paper

25. 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?