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Key Concepts and Skills

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0 Chapter 18 Short-Term Finance and Planning
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

1 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 18-1

2 Chapter Outline Tracing Cash and Net Working Capital
The Operating Cycle and the Cash Cycle Some Aspects of Short-Term Financial Policy The Cash Budget Short-Term Borrowing A Short-Term Financial Plan Lecture Tip: For some reason, many students (and some faculty) view short-term finance generally, and working capital management specifically, as less important than capital budgeting or the risk-return relationship. You may find it useful to emphasize the importance of short-term finance in introducing the current chapter. First, discussions with CFOs quickly lead to the conclusion that, as important as capital budgeting and capital structure decisions are, they are made less frequently, while the day-to-day complexities involving the management of net working capital (especially cash and inventory) consume tremendous amounts of management time. Second, it is clear that while poor long-term investment and financing decisions will adversely impact firm value, poor short-term financial decisions will impair the firm’s ability to continue operating. Finally, good working capital decisions can also have a major impact on firm value. 18-2

3 Sources and Uses of Cash
Balance sheet identity (rearranged) NWC + fixed assets = long-term debt + equity NWC = cash + other CA – CL Cash = long-term debt + equity + CL – CA other than cash – fixed assets Sources Increasing long-term debt, equity, or current liabilities Decreasing current assets other than cash, or fixed assets Uses Decreasing long-term debt, equity, or current liabilities Increasing current assets other than cash, or fixed assets Lecture Tip: Concept question 18.1b asks students to consider whether net working capital always increases when cash increases. The best way to illustrate why the answer to this is “no” is to work an example: Suppose a firm currently has $50,000 in current assets and $20,000 in current liabilities; so NWC = $50,000 – 20,000 = 30,000. Management decides to borrow $10,000 using long-term debt. What happens to cash and NWC? Cash increases by $10,000 and NWC = (50, ,000) – 20,000 = 40,000. So, both cash and NWC increase by 10,000. Suppose, on the other hand, management borrowed the $10,000 from a bank as a short-term loan. Cash still increases by $10,000, but net working capital doesn’t change ( NWC = (50, ,000) – (20, ,000) = 30,000). The effect of an increase in cash on NWC depends on where the increase comes from; if the increase comes from a change in long-term liabilities, equity or fixed assets, then there will be an increase in NWC. On the other hand, if the increase comes from a change in current liabilities or current assets, then there will be no impact on NWC. 18-3

4 The Operating Cycle Operating cycle – time between purchasing the inventory and collecting the cash from sale of the inventory Inventory period – time required to purchase and sell the inventory Accounts receivable period – time required to collect on credit sales Operating cycle = inventory period + accounts receivable period 18-4

5 Cash Cycle Cash cycle Amount of time we finance our inventory Difference between when we receive cash from the sale and when we have to pay for the inventory Accounts payable period – time between purchase of inventory and payment for the inventory Cash cycle = Operating cycle – accounts payable period Lecture Tip: Students should recognize that a company would prefer to take as long as possible before paying bills. You might mention that accounts payable is often viewed as “free credit;” however, the cost of granting credit is built into the cost of the product. Note that the operating cycle begins when inventory is purchased and the cash cycle begins with the payment of accounts payable. 18-5

6 Figure 18.1 18-6

7 Example Information Inventory: Accounts Receivable: Accounts Payable:
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 Lecture Tip: In this chapter, we use average values of inventory, accounts receivable, and accounts payable to compute values of inventory turnover, accounts receivable turnover and accounts payable turnover, respectively. Remind students that the balance sheet represents a financial “snapshot” of the firm and, as such, balance sheet values literally change on a daily basis. One way to reduce the distortions caused by dividing a “snapshot” value by a “flow” value (income statement numbers that represent what has happened over a period of time) is to use the average “snapshot” value computed over the same period. 18-7

8 Example – Operating Cycle
Inventory period Average inventory = (200, ,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)/2 = 180,000 Receivables turnover = 1,150,000 / 180,000 = 6.39 times Receivables period = 365 / 6.39 = 57 days Operating cycle = = 168 days 18-8

9 Example – Cash Cycle Payables Period Cash Cycle = 168 – 39 = 129 days
Average payables = (75, ,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 extensive. A comparison to industry averages would help solidify this assertion. Lecture Tip: It may be beneficial to have students consider the interactions imbedded in the cash cycle. For example, students may feel that the main demand on funds, for example, comes from the inventory period. However, the students should consider the interactions involved when trying to speed up the inventory turnover. Increasing inventory turnover may involve relaxing credit terms, which will result in a lower receivables turnover. The ultimate effect will depend on the trade-off between the two and the cash flows that are generated. Real-World Tip: This discussion suggests that, depending on inventory needs and financing costs, some firms will find it useful to hire others to “store inventory” for them. In fact, Boeing/McDonnell-Douglas Aircraft in St. Louis does exactly that – small firms are paid to guarantee the delivery of raw materials (copper, sheet steel, etc.) to the firm at a moment’s notice. And while these firms also do some preliminary cutting and machining, their primary role is to hold inventory that Boeing/McDonnell-Douglas would otherwise have to hold. As a result, the firm’s financing needs are lessened. The relationship between inventory turnover and financing needs is also apparent in industries with extremely long or short cash cycles. For example, cash cycles are relatively long in the jewelry retailing industry, and particularly short in the grocery industry. The financing implications are obvious. 18-9

10 Short-Term Financial Policy
Size of investments in current assets Flexible (conservative) policy – maintain a high ratio of current assets to sales Restrictive (aggressive) policy – maintain a low ratio of current assets to sales Financing of current assets Flexible (conservative) policy – less short-term debt and more long-term debt Restrictive (aggressive) policy – more short-term debt and less long-term debt 18-10

11 Carrying vs. Shortage Costs
Managing short-term assets involves a trade-off between carrying costs and shortage costs Carrying costs – increase with increased levels of current assets, the costs to store and finance the assets Shortage costs – decrease with increased levels of current assets Trading or order costs Costs related to safety reserves, i.e., lost sales and customers, and production stoppages Lecture Tip: The just-in-time inventory system is designed to reduce the inventory period. In essence, companies pay their suppliers to carry the inventory for them. Reducing the inventory period reduces the operating cycle and thus the cash cycle. This reduces the need for financing. Ask the students to consider what type of cost is being minimized and what costs are likely to increase. Ask them if JIT inventory policies are appropriate for all industries. It makes sense for industries that have substantial carrying costs with relatively low shortage costs, but not for industries where shortage costs outweigh carrying costs. 18-11

12 Temporary vs. Permanent Assets
Temporary current assets Sales or required inventory build-up may be seasonal Additional current assets are needed during the “peak” time The level of current assets will decrease as sales occur Permanent current assets Firms generally need to carry a minimum level of current assets at all times These assets are considered “permanent” because the level is constant, not because the assets aren’t sold See the Lecture Tip in the IM for an example illustrating the difference between permanent and temporary assets. 18-12

13 Figure 18.4 18-13

14 Choosing the Best Policy
Cash reserves High 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 opportunities Cash and marketable securities earn a lower return and are zero NPV investments Maturity hedging Try to match financing maturities with asset maturities Finance temporary current assets with short-term debt Finance permanent current assets and fixed assets with long-term debt and equity Interest Rates Short-term rates are normally lower than long-term rates, so it may be cheaper to finance with short-term debt Firms 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 loans Have to consider all these factors and determine a compromise policy that fits the needs of the firm Lecture Tip: Personal financial situations provide ample examples of maturity matching. We tend to use 30-year loans when we buy houses (expectation that a house has a long useful life) and 4 –5 year loans for cars. Why wouldn’t we finance these assets with short-term loans? What if you borrowed $200,000 to buy a house using a 1-year note? In one year, you either have to pay off the loan with cash or refinance. If you refinance, you have the transaction costs associated with obtaining a new loan and the possibility that rates increased substantially during the year. Adjustable loans may adjust annually, but the initial rate is generally lower than a fixed rate loan and there are limits to how much the loan rate can increase in any given year and over the life of the loan. Also, there are no transaction costs associated with the rate adjustment on an ARM. Ask borrowers caught up in the mortgage and credit crisis in 2008 about the risk associated with short-term financing strategies. 18-14

15 Figure 18.6 18-15

16 Cash Budget Forecast of cash inflows and outflows over the next short-term planning period Primary tool in short-term financial planning Helps determine when the firm should experience cash surpluses and when it will need to borrow to cover working-capital requirements Allows a company to plan ahead and begin the search for financing before the money is actually needed 18-16

17 Example: Cash Budget Information
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 18-17

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 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 267 18-18

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 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 Total cash disbursements 475 743 607 628 Payment of accounts: Q1: (600)/2 = 275 Q2: (650)/2 = 313 (rounded to nearest dollar throughout) Q3: (800)/2 = 362 Q4: (550)/2 = 338 18-19

20 Example: Cash Budget – Net Cash Flow and Cash Balance
Q1 Q2 Q3 Q4 Total 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 160 Minimum cash balance -50 Cumulative surplus (deficit) 138 -38 -12 110 The company will need to access a line of credit or borrow short-term to pay for the short-fall in quarter 2, but it should be able to clear up the line of credit in quarter 4. 18-20

21 Short-Term Borrowing Unsecured Loans Secured Loans Commercial Paper
Line of credit Committed vs. noncommitted Revolving credit arrangement Letter of credit Secured Loans Accounts receivable financing Assigning Factoring Inventory loans Blanket inventory lien Trust receipt Field warehouse financing Commercial Paper Trade Credit Lecture Tip: Credit cards are an excellent way to illustrate the concept of a “personal” line of credit. The consumer can use the line of credit on the credit card to purchase goods or services. The line of credit remains active until we abuse the privilege (i.e., late payments). There is often a cost for this line of credit in the form of annual fees. This is in addition to the often high rates of interest. College students are often targeted by credit card companies and end up holding several cards at one time. The cost of the annual fees can add up – especially if they don’t need the additional credit to begin with. Students also have the habit of charging to their limits and then just making the minimum payment. Lecture Tip: Inventory needs to be non-perishable and marketable and not subject to obsolescence in order to be useful for inventory loans. Some view inventory financing as a means of raising additional short-term funds after receivables financing has been exhausted; however, it is standard practice in some industries, such as auto sales. A description of a typical commercial paper transaction is included in a Lecture Tip in the IM. 18-21

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) = 176,471 What interest rate are we effectively paying? Interest paid = 176,471(.09) = 15,882 Effective 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 with a negative sign = -165,882; N = 1; CPT I = % Lecture Tip: Trade credit represents another source of unsecured financing. However, the cost of this form of borrowing is largely implicit, since it is represented by the opportunity cost of not taking the discount offered, if any. To compute the effective annual cost of trade credit, we first use the credit terms to determine a periodic opportunity cost. For example, if the terms are 2/10 net 30, rational managers will either pay $.98 per dollar of goods ordered on the 10th day, or the full invoice cost on the 30th day. In the latter case, the firm is actually paying $.02 to borrow $0.98 for 20 days. In one year, there are 365 / 20 = such periods. Therefore, the annualized cost is ( /.98)18.25 – 1 = 44.58%. 18-22

23 Example: Factoring Last 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 times APR = 12(.02/.98) = or 24.49% EAR = (1+.02/.98)12 – 1 = or 27.43% Remind students that this interest is a cost in this situation, not a return. 18-23

24 Short-Term Financial Plan
Q1 Q2 Q3 Q4 Beginning cash balance 80 188 50 Net cash inflow 108 (176) 26 122 New short-term borrowing 38 Interest on short-term investment (loan) 1 (1) Short-term borrowing repaid 25 13 Ending cash balance 159 Minimum cash balance (50) Cumulative surplus (deficit) 138 109 Beginning short-term debt Change in short-term debt (25) (13) Ending short-term debt Short-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 0 (i.e., = excess cash = 30; 30*.02/4 = .15) Q2 interest received = .69 rounds to 1 Q3 interest paid = 1.14 rounds to 1 Q4 interest paid = .39 rounds to 0 18-24

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? 18-25

26 Ethics Issues A large retailer such as Wal-Mart possesses power over smaller suppliers. In theory, Wal-Mart could force these suppliers to sell on payment terms that were well beyond a typical industry norm. How would this impact Wal-Mart’s cash cycle? How would this impact the supplier’s cycle? Are there any ethical issues involved in such a practice? 18-26

27 Comprehensive Problem
With a quoted interest rate of 5% and a 10% compensating balance, what is the effective rate of interest (use a $200,000 loan proceeds amount)? With average accounts receivable of $5 million and credit sales of $24 million, you factor receivables by discounting them 2%. What is the effective rate of interest? Borrow $200,000 / (1 - .1) = $222,222 Pay interest of .05 x $222,222 = $11,111 Effective rate of interest = $11,111/$200,000 = = 5.56% Receivables turnover = $24/$5 = 4.8 times APR = 4.8(.02/.98) = = 9.8% EAR = {[1+(.098/4.8)]^4.8}-1=10.19% 18-27

28 End of Chapter 18-28

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