Presentation on theme: "Key Concepts and Skills"— Presentation transcript:
0 Short-Term Finance and Planning 19Short-Term Finance and Planning
1 Key Concepts and Skills Understand the components of the cash cycle and why it is importantUnderstand the pros and cons of the various short-term financing policiesBe able to prepare a cash budgetUnderstand the various options for short-term financing
2 Chapter Outline Tracing Cash and Net Working Capital The Operating Cycle and the Cash CycleSome Aspects of Short-Term Financial PolicyThe Cash BudgetShort-Term BorrowingA Short-Term Financial Plan
3 Sources and Uses of Cash Balance sheet identity (rearranged)NWC + fixed assets = long-term debt + equityNWC = cash + other CA – CLCash = long-term debt + equity + CL – CA other than cash – fixed assetsSourcesIncreasing long-term debt, equity or current liabilitiesDecreasing current assets other than cash or fixed assetsUsesDecreasing long-term debt, equity or current liabilitiesIncreasing current assets other than cash or fixed assets
4 The Operating CycleOperating cycle – time between purchasing the inventory and collecting the cash from selling the inventoryInventory period – time required to purchase and sell the inventoryAccounts receivable period – time required to collect on credit salesOperating cycle = inventory period + accounts receivable period
5 Cash CycleCash cycleAmount of time we finance our inventoryDifference between when we receive cash from the sale and when we have to pay for the inventoryAccounts payable period – time between purchase of inventory and payment for the inventoryCash cycle = Operating cycle – accounts payable period
7 Example Information Inventory: Accounts Receivable: Accounts Payable: Beginning = 200,000Ending = 300,000Accounts Receivable:Beginning = 160,000Ending = 200,000Accounts Payable:Beginning = 75,000Ending = 100,000Net sales = 1,150,000Cost of Goods sold = 820,000
8 Example – Operating Cycle Inventory periodAverage inventory = (200, ,000)/2 = 250,000Inventory turnover = 820,000 / 250,000 = 3.28 timesInventory period = 365 / 3.28 = 112 daysReceivables periodAverage receivables = (160, ,000)/2 = 180,000Receivables turnover = 1,150,000 / 180,000 = 6.39 timesReceivables period = 365 / 6.39 = 58 daysOperating cycle = = 170 daysNote if there were fractional days, I rounded up.
9 Example – Cash Cycle Payables Period Cash Cycle = 170 – 39 = 131 days Average payables = (75, ,000)/2 = 87,500Payables turnover = 820,000 / 87,500 = 9.37 timesPayables period = 365 / 9.37 = 39 daysCash Cycle = 170 – 39 = 131 daysWe have to finance our inventory for 131 daysIf we want to reduce our financing needs, we need to look carefully at our receivables and inventory periods – they both seem extensive
10 Short-Term Financial Policy Size of investments in current assetsFlexible (conservative) policy – maintain a high ratio of current assets to salesRestrictive (aggressive) policy – maintain a low ratio of current assets to salesFinancing of current assetsFlexible (conservative) policy – less short-term debt and more long-term debtRestrictive (aggressive) policy – more short-term debt and less long-term debt
11 Carrying vs. Shortage Costs Managing short-term assets involves a trade-off between carrying costs and shortage costsCarrying costs – increase with increased levels of current assets, the costs to store and finance the assetsShortage costs – decrease with increased levels of current assetsTrading or order costsCosts related to safety reserves, i.e., lost sales and customers and production stoppages
12 Temporary vs. Permanent Assets Temporary current assetsSales or required inventory build-up may be seasonalAdditional current assets are needed during the “peak” timeThe level of current assets will decrease as sales occurPermanent current assetsFirms generally need to carry a minimum level of current assets at all timesThese assets are considered “permanent” because the level is constant, not because the assets aren’t sold
14 Choosing the Best Policy Cash reservesHigh cash reserves mean that firms will be less likely to experience financial distress and are better able to handle emergencies or take advantage of unexpected opportunitiesCash and marketable securities earn a lower return and are zero NPV investmentsMaturity hedgingTry to match financing maturities with asset maturitiesFinance temporary current assets with short-term debtFinance permanent current assets and fixed assets with long-term debt and equityInterest RatesShort-term rates are normally lower than long-term rates, so it may be cheaper to finance with short-term debtFirms can get into trouble if rates increase quickly or if it begins to have difficulty making payments – may not be able to refinance the short-term loansHave to consider all these factors and determine a compromise policy that fits the needs of the firm
16 Cash BudgetForecast of cash inflows and outflows over the next short-term planning periodPrimary tool in short-term financial planningHelps determine when the firm should experience cash surpluses and when it will need to borrow to cover working-capital costsAllows a company to plan ahead and begin the search for financing before the money is actually needed
17 Example: Cash Budget Information Pet Treats Inc. specializes in gourmet pet treats and receives all income from salesSales estimates (in millions)Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550Accounts receivableBeginning receivables = $250Average collection period = 30 daysAccounts payablePurchases = 50% of next quarter’s salesBeginning payables = 125Accounts payable period is 45 daysOther expensesWages, taxes and other expense are 30% of salesInterest and dividend payments are $50A major capital expenditure of $200 is expected in the second quarterThe initial cash balance is $80 and the company maintains a minimum balance of $50
18 Example: Cash Budget – Cash Collections 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 quarterBeginning receivables of $250 will be collected in the first quarterQ1Q2Q3Q4Beginning Receivables250167200217Sales500600650800Cash Collections583567633750Ending Receivables267
19 Example: Cash Budget – Cash Disbursements Payables period is 45 days, so half of the purchases will be paid for each quarter and the remaining will be paid the following quarterBeginning payables = $125Q1Q2Q3Q4Payment of accounts275313362338Wages, taxes and other expenses150180195240Capital expenditures200Interest and dividend payments50Total cash disbursements475743607628Payment of accounts:Q1: (600)/2 = 275Q2: (650)/2 = 313 (rounded to nearest dollar throughout)Q3: (800)/2 = 362Q4: (550)/2 = 338
20 Example: Cash Budget – Net Cash Flow and Cash Balance Q1Q2Q3Q4Total cash collections583567633750Total cash disbursements475743607628Net cash inflow108-17626122Beginning Cash Balance801881238Ending cash balance160Minimum cash balance-50Cumulative surplus (deficit)138-39-14107The company will need to access a line of credit or borrow short-term to pay for the short-fall in quarter 2, but should be able to clear up the line of credit in quarter 4.
21 Short-Term Borrowing Unsecured Loans Secured Loans Commercial Paper Line of creditCommitted vs. noncommittedRevolving credit arrangementLetter of creditSecured LoansAccounts receivable financingAssigningFactoringInventory loansBlanket inventory lienTrust receiptField warehouse financingCommercial PaperTrade Credit
22 Example: Compensating Balance We have a $500,000 line of credit with a 15% compensating balance requirement. The quoted interest rate is 9%. We need to borrow $150,000 for inventory for one year.How much do we need to borrow?150,000/(1-.15) = 176,471What interest rate are we effectively paying?Interest paid = 176,471(.09) = 15,882Effective rate = 15,882/150,000 = or 10.59%Note that this method of finding the effective rate only works if we are borrowing the money for one year. If we are borrowing the money for less than one year, enter the amount available for use today as the PV and the repayment amount after subtracting the money available from the compensating balance as the FV (remember the negative sign), then enter N as the fraction of a year and compute I. For example, PV = 150,000; FV = 176, ,882 – 26,471 = -165,882; N = 1; CPT I = %
23 Example: FactoringLast year your company had average accounts receivable of $2 million. Credit sales were $24 million. You factor receivables by discounting them 2%. What is the effective rate of interest?Receivables turnover = 24/2 = 12 timesAPR = 12(.02/.98) = or 24.49%EAR = (1+.02/.98)12 – 1 = or 27.43%
24 Short-Term Financial Plan Q1Q2Q3Q4Beginning cash balance8018850Net cash inflow108(176)26122New short-term borrowing38Interest on short-term investment (loan)1(1)Short-term borrowing repaid2513Ending cash balance159Minimum cash balance(50)Cumulative surplus (deficit)138109Beginning short-term debtChange in short-term debt(25)(13)Ending short-term debtShort-term funds are borrowed at 12% and interest is compounded quarterly.Short-term surpluses are invested at 2% and interest is compounded quarterly.Q1 interest received = .15 rounds to 0Q2 interest received = .69 rounds to 1Q3 interest paid = 1.11 rounds to 1Q4 interest paid = .36 rounds to 0
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?