1. © 2003 The McGraw-Hill Companies, Inc. All rights reserved. Short-Term Finance and Planning Chapter Eighteen Prepared by Anne Inglis, Ryerson University

2. 18.1 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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. 18.2 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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 A Short-Term Financial Plan Short-Term Borrowing

4. 18.3 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Sources and Uses of Cash 18.1 Balance sheet identity (rearranged) –Net working capital + fixed assets = long-term debt + equity –Net working capital = cash + other CA – CL –Cash = long-term debt + equity + current liabilities – current assets 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

5. 18.4 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. The Operating Cycle 18.2 Operating cycle – time between purchasing the inventory and collecting the cash Inventory period – time required to purchase and sell the inventory Accounts receivable period – time to collect on credit sales Operating cycle = inventory period + accounts receivable period

6. 18.5 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. The Cash Cycle Cash cycle –time period for which we need to 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

7. 18.6 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 18.1 – Cash Flow Time Line

8. 18.7 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example Information Inventory: –Beginning = 5000 –Ending = 6000 Accounts Receivable: –Beginning = 4000 –Ending = 5000 Accounts Payable: –Beginning = 2200 –Ending = 3500 Net sales = 30,000 (assume all sales are on credit) Cost of Goods sold = 12,000

9. 18.8 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example – Operating Cycle Inventory period –Average inventory = (5000 + 6000)/2 = 5500 –Inventory turnover = 12,000 / 5500 = 2.18 times –Inventory period = 365 / 2.18 = 167 days Receivables period –Average receivables = (4000 + 5000)/2 = 4500 –Receivables turnover = 30,000/4500 = 6.67 times –Receivables period = 365 / 6.67 = 55 days Operating cycle = 167 + 55 = 222 days

10. 18.9 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example – Cash Cycle Payables Period –Average payables = (2200 + 3500)/2 = 2850 –Payables turnover = 12,000/2850 = 4.21 –Payables period = 365 / 4.21 = 87 days Cash Cycle = 222 – 87 = 135 days We have to finance our inventory for 135 days We need to be looking more carefully at our receivables and our payables periods – they both seem extensive

11. 18.10 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Short-Term Financial Policy 18.3 Size of investments in current assets –Flexible policy – maintain a high ratio of current assets to sales –Restrictive policy – maintain a low ratio of current assets to sales Financing of current assets –Flexible policy – less short-term debt and more long-term debt –Restrictive policy – more short-term debt and less long-term debt

12. 18.11 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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, the costs to replenish assets Trading or order costs Costs related to safety reserves, i.e., lost sales, lost customers and production stoppages

13. 18.12 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 18.2 – Carrying Costs and Storage Costs

14. 18.13 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 18.2 – Carrying Costs and Storage Costs

15. 18.14 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Temporary vs. Permanent Assets Temporary current assets –Sales or required inventory build-up are often seasonal –The additional current assets carried 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

16. 18.15 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 18.4 – Total Asset Requirement Over Time

17. 18.16 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Choosing the Best Policy Cash reserves –Pros – firms will be less likely to experience financial distress and are better able to handle emergencies or take advantage of unexpected opportunities –Cons – 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

18. 18.17 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Choosing the Best Policy continued Relative 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 your firm

19. 18.18 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Figure 18.6 – A Compromise Financing Policy

20. 18.19 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. The Cash Budget 18.4 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 costs Allows a company to plan ahead and begin the search for financing before the money is actually needed

21. 18.20 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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 25% 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 $100 and the company maintains a minimum balance of $50

22. 18.21 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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 Q1Q2Q3Q4 Beginning Receivables250167200217 Sales500600650800 Cash Collections583567633750 Ending Receivables167200217267

23. 18.22 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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 Q1Q2Q3Q4 Payment of accounts275438362338 Wages, taxes and other expenses125150163200 Capital expenditures200 Interest and dividend payments50 Total cash disbursements450838575588

24. 18.23 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example: Cash Budget – Net Cash Flow and Cash Balance Q1Q2Q3Q4 Total cash collections583567633750 Total cash disbursements450838575588 Net cash inflow133 -271 58162 Beginning Cash Balance100233-3820 Net cash inflow133 -271 58162 Ending cash balance233-3820182 Minimum cash balance-50 Cumulative surplus (deficit)183-88-30132

25. 18.24 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Short-Term Financial Plan 18.5 Q1Q2Q3Q4 Beginning cash balance10023350 Net cash inflow133-27158162 New short-term borrowing88 Interest on short-term borrowing31 Short-term borrowing repaid5533 Ending cash balance23350 178 Minimum cash balance-50 Cumulative surplus (deficit)18300128 Beginning short-term debt08833 Change in short-term debt088-55-33 Ending short-term debt088330

26. 18.25 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Short-Term Borrowing 18.6 Operating Loans –Committed vs. noncommitted Letter of credit Accounts receivable financing Covenants Factoring Securitizing Receivables Inventory Loans Trade Credit Money Market Financing

27. 18.26 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example: Compensating Balance We have a $500,000 operating loan 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 =.1059 or 10.59%

28. 18.27 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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 –Average collection period = 365/12 = 30.4 days –APR = 12(.02/.98) =.2449 or 24.49% –EAR = (1+.02/.98) 12 – 1 =.2743 or 27.43%

29. 18.28 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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?

30. 18.29 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Summary 18.7 Short-term finance involves short-lived assets and liabilities. Current assets and current liabilities arise in the short-term operating activities and the cash cycle of the firm Managing short-term cash flows finding the optimal trade-off between carrying costs and shortage costs Cash budgets are used to identify short-term financial needs in advance The firm can then finance the shortfall