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
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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.
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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.
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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
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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.
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6. Figure 18.1
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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.
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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
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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.
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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
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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.
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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.
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13. Figure 18.4
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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.
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15. Figure 18.6
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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
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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
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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
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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
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20. Example: Cash Budget – Net Cash Flow and Cash BalanceQ1 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.
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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.
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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%.
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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.
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24. Short-Term Financial PlanQ1 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
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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?
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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?
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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%
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28. End of Chapter
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