1. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.0 Chapter 16 Short-Term Financial Planning

2. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.1 16.3 Some Aspects of Short-Term Financial Policy

3. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.2 Some Aspects of Short-Term Financial Policy The short-term financial policy that a firm adopts will be reflected in at least two ways: 1. The size of the firm’s investment in current assets 2. The financing of current assets

4. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.3 Some Aspects of Short-Term Financial Policy 1. The size of the firm’s investment in current assets Relative to: the firm’s level of total operating revenues Flexible short-term financial policy – high ratio of current assets to sales Restrictive short-term financial policy – low ratio of current assets to sales

5. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.4 Some Aspects of Short-Term Financial Policy 2. The financing of current assets Measured as the proportion of short-term debt (current liabilities) and long-term debt used to finance current assets Flexible short-term financial policy – means less short-term debt and more long term debt Restrictive short-term financial policy – means a high proportion of short-term debt relative to long-term financing

6. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.5 Short-Term Financial Policy Flexible (Conservative) Policy Large amounts of cash and marketable securities Large amounts of inventory Liberal credit policies (large accounts receivable) Relatively low levels of short-term liabilities High liquidity Restrictive (Aggressive) Policy Low cash and marketable security balances Low inventory levels Little or no credit sales (low accounts receivable) Relatively high levels of short-term liabilities Low liquidity

7. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.6 The Size of the Firm’s Investment in Current Assets Flexible short-term financial policies are costly They require a greater investment in cash and marketable securities, inventory, and accounts receivable However, future cash inflows should be higher: Sales are stimulated by the use of a credit policy that provides liberal financing to customers A large amount of finished inventory on hand (“on the shelf”) provides a quick delivery service to customers and may increase sales A large inventory of raw materials may result in fewer production stoppages because of inventory shortages

8. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.7 The Size of the Firm’s Investment in Current Assets A more restrictive short-term financial policy probably reduces future sales levels below those that would be achieved under flexible policies Also, it’s possible that higher prices can be charged to customers under flexible working capital policies: Customers may be willing to pay higher prices for: Quick delivery service More liberal credit terms implicit in flexible policies

9. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.8 Carrying versus Shortage Costs Carrying Costs: Costs that rise with increases in the level of investment in current assets Cost of storing larger amounts of inventory Opportunity cost of owning current assets versus long- term assets that pay higher returns

10. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.9 Carrying versus Shortage Costs Shortage costs: Costs of the firm that fall with increased levels of investment in its current assets Shortage costs are incurred when investment in current assets is low. Trading, or Order Costs costs of placing an order for more cash (brokerage costs) more inventory (production setup) costs Costs related to lack of safety reserves costs of lost sales lost customer goodwill disruption of production schedules due to lack of inventory

11. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.10 Figure 16.4 – Page 458 Policy F always implies a short-term cash surplus and a large investment in cash and marketable securities. Dollars Policy FPolicy R Long-term financing Total asset requirement Marketable securities Time Long-term financing Time Total asset requirement Short-term financing Policy R uses long-term financing for permanent asset requirements only and short-term borrowing for seasonal variations.

12. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.11 Which Financing Policy Is Best? Several considerations must be included in a proper analysis of the most appropriate amount of short-term borrowing: 1. Cash reserves – the flexible financing policy implies surplus cash and little short-term borrowing Reduces the probability that a firm will experience financial distress However, investments in cash and marketable securities are zero net present value investments Investing excess cash obtained from long-term financing in a short-term investment.

13. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.12 Which Financing Policy Is Best? 2. Maturity hedging – most firms attempt to match the maturities of assets and liabilities Finance inventories with short-term bank loans and fixed assets with long-term financing Financing long-lived assets with short-term borrowing would necessitate frequent refinancing Inherently risky: short-term interest rates are more volatile than longer-term rates

14. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.13 Which Financing Policy Is Best? 3. Relative interest rates Short-term interest rates are usually lower than long- term rates on average, it’s more costly to rely on long-term borrowing as compared to short-term borrowing

15. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.14 Which Financing Policy Is Best? The two policies, flexible and restrictive, are extremes. With a flexible financial policy – the firm never does any short-term borrowing With the restrictive financial policy – the firm never has a cash reserve (marketable securities)

16. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.15 Which Financing Policy Is Best? With a compromise policy: The firm borrows in the short term to cover peak financing needs But maintains a cash reserve in the form of marketable securities during slow periods As current assets build up, the firm draws down this reserve before doing any short-term borrowing This allows for some run-up in current assets before the firm has to resort to short-term borrowing

17. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.16 Figure 16.5 Dollars Time Flexible policy (F) Compromise policy (C) Restrictive policy (R) Short-term financing Total seasonal variation Marketable securities General growth in fixed assets and permanent current assets With a compromise policy, the firm keeps a reserve of liquidity that it uses to initially finance seasonal variations in current asset needs. Short-term borrowing is used when the reserve is exhausted.

18. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.17 16.4 The Cash Budget

19. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.18 The Cash Budget Cash Budget: A forecast of cash receipts and disbursements for the next planning period Primary tool in short-run financial planning Identifies short-term financial needs and opportunities Identifies when short-term financing may be required How it works: It records estimates of cash receipts (cash in) and disbursements (cash out). The result is an estimate of the cash surplus or deficit

20. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.19 The Cash Budget Example: The Cash Budget Pages 461, 462. 463 Excel Spreadsheet

21. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.20 16.5 Short-Term Borrowing

22. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.21 Unsecured Loans The most common way to finance a temporary cash deficit is to arrange a short-term, “unsecured” bank loan. Line of Credit: A formal (committed) or informal (noncommitted) prearranged, short-term bank loan An agreement under which a firm is “authorized” to borrow up to a specified amount. To ensure the line is used for short-term purposes: the borrower will sometimes be required to pay the line down to zero and keep it there for some period during the year typically 60 days (called a cleanup period)

23. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.22 Unsecured Loans Short-term lines of credit are classified as either committed or noncommitted. Noncommitted – an “informal” arrangement that allows firms to borrow up to a previously specified limit without going through the normal paperwork (much as you would with a credit card). Line of credit – usually evaluated on an annual basis Revolving credit arrangement (revolver) – similar to a line of credit, but usually open for two or more years

24. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.23 Unsecured Loans Committed lines of credit: Are more “formal” legal arrangements Often involve a commitment fee paid by the firm to the bank Essentially the firm is buying insurance to guarantee that the bank can’t back out of the agreement (absent some material change in the borrower’s status) The interest rate will usually float

25. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.24 Secured Loans Banks and other finance companies often require “security” for a short-term loan just as they do for a long-term loan. Security for short-term loans usually consists of: Accounts Receivable Inventories Or Both

26. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.25 Accounts Receivable Financing Accounts Receivable Financing: A “secured” short-term loan that involves either the Assignment or Factoring of receivables. Assignment – the lender has the receivables as security, but the borrower is still responsible if a receivable can’t be collected.

27. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.26 Accounts Receivable Financing Factoring – the receivable is discounted and sold to the lender (the factor) The factor typically buys the receivable at a discount Once sold, collection is the factor’s problem The factor assumes the full risk of default on bad accounts The factor is providing insurance as well as immediate cash. The factor essentially takes over the firm’s credit operations. This can result in significant savings.

28. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.27 Inventory Loans Inventory Loan: A “secured” short-term loan to purchase inventory. (3 basic forms) 1. Blanket inventory lien – gives the lender a lien against all the borrower’s inventories (the blanket “covers” everything) 2. Trust receipt – the borrower holds specific inventory in “trust” for the lender. Auto dealer financing is done by trust receipts – Also called floor planning (in reference to inventory on the showroom floor).

29. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.28 Inventory Loans 3. Field warehouse financing – a public warehouse company (an independent company that specializes in inventory management) acts as a control agent to supervise the inventory for the lender.

30. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.29 Other Sources There are a variety of other sources of short- term funds employed by corporations. Two of the most important are: Commercial Paper Trade Credit

31. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.30 Other Sources Commercial Paper - consists of short-term notes issued by large and highly rated firms. Typically short maturity Ranging up to 270 days beyond that limit, the firm must file a registration statement with the SEC The firm issues Commercial Paper directly The interest rate the borrowing firm obtains can be significantly below the rate a bank would charge for a direct loan.

32. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.31 Other Sources Trade Credit – increasing the accounts payable period by taking longer to pay bills. This amounts to borrowing from suppliers in the form of trade credit. An extremely important form of financing for smaller businesses However, may end up paying a much higher price for purchases, so this can be a very expensive source of financing

33. McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.32 Suggested Homework and Test Review Know chapter theories, concepts, and definitions Know how to calculate: Inventory turnover Inventory period Receivables turnover Receivables period Payables turnover Payables period Length of the Operating Cycle Length of the Cash Cycle Chapter Review and Self-Test Problem 16.1 – Page 467-8 (Worked in class) (There will be a problem like this one on the exam – 8 questions.)