Short-Term Finance and Planning 18 Short-Term Finance and Planning Prepared by Anne Inglis Edited by William Rentz

Key Concepts and Skills Understand the components of the operating and cash cycles and why they are important Know the types of short-term financial policy Know the sources and uses of cash on the Statement of Change in Financial Position Know the different types of short-term borrowing

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 (omitted) A Short-Term Financial Plan (omitted) Short-Term Borrowing Summary and Conclusions

Sources and Uses of Cash 18.1 LO4 Statement of Change in Financial Position identity (rearranged) Net working capital + Fixed assets = Long-term debt + Equity NWC = Cash + other CA – CL Cash = Long-term debt + Equity + Current liabilities – Current assets other than cash – Fixed assets

Sources and Uses of Cash - continued LO4 Sources Increasing long-term debt, equity or current liabilities Decreasing fixed assets or current assets other than cash Uses Decreasing long-term debt, equity or current liabilities Increasing fixed assets or current assets other than cash

The Operating Cycle 18.2 LO1 Operating cycle – time between purchasing the inventory and collecting the cash from credit sales 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

The Cash Cycle Cash cycle LO1 Cash cycle Time period for which we need to finance our Inventory + Accounts receivables 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

Figure 18.1 – Cash Flow Time Line

Example Information Inventory: Accounts receivable: Accounts payable: LO1 Inventory: Beginning = $5,000 Ending = $6,000 Accounts receivable: Beginning = $4,000 Ending = $5,000 Accounts payable: Beginning = $2,200 Ending = $3,500 Net sales = $30,000 (assume all sales are on credit) Cost of goods sold = $12,000

Example – Operating Cycle LO1 Inventory period Average inventory = ($5,000 + $6,000)/2 = $5,500 Inventory turnover = $12,000 / $5,500 = 2.18 times Inventory period = 365 / 2.18 = 167 days Receivables period Average receivables = ($4,000 + $5,000)/2 = $4,500 Receivables turnover = $30,000/$4,500 = 6.67 times Receivables period = 365 / 6.67 = 55 days Operating cycle = 167 + 55 = 222 days

Example – Cash Cycle Payables period Cash cycle = 222 – 87 = 135 days LO1 Payables period Average payables = ($2,200 + $3,500)/2 = $2,850 Payables turnover = $12,000 / $2,850 = 4.21 Payables period = 365 / 4.21 = 87 days Cash cycle = 222 – 87 = 135 days We finance our Inventory + AR for 135 days We need to be looking more carefully at our receivables and our payables periods – they both seem excessive

Short-Term Financial Policy 18.3 LO2 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

Carrying vs. Shortage Costs LO2 Managing short-term assets involves a trade-off between carrying costs and shortage costs Carrying costs – INCREASE with INCREASED level of current assets, costs to store & finance assets Shortage costs – DECREASE with INCREASED level of current assets, the costs to replenish assets Trading or order costs Costs related to insufficient safety reserves, i.e., lost sales, lost customers & production stoppages

Figure 18.2 – Carrying Costs and Storage Costs LO2

Figure 18.2 – Carrying Costs and Storage Costs LO2

Temporary vs. Permanent Assets LO2 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 are not sold

Figure 18.4 – Total Asset Requirement Over Time LO2

Choosing the Best Policy LO2 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

Choosing the Best Policy continued LO2 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

Choosing the Best Policy continued LO2 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

Figure 18.6 – A Compromise Financing Policy LO2

Short-Term Borrowing 18.6 Operating Loans (lines of credit) Committed vs. Non-Committed Letter of credit (international financing) Revocable or Irrevocable Accounts receivable financing Covenants Factoring Securitizing Receivables (finance subsidiary) Inventory Loans Trust receipts, Floor planning Trade Credit Money Market Financing Commercial paper, Bankers acceptances

Example: Compensating Balance (Bank Act forbids banks requesting such a requirement) LO5 We have a $500,000 operating loan with a 15% compensating balance requirement The quoted interest rate is 9% Need to borrow $150,000 for one year How much do we actually 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% NB. 9%/(1 - .15) = 10.59% Note that this method of finding the effective rate only works if we are borrowing the money for one year.

Example: Factoring Average accounts receivable are $2M LO5 Average accounts receivable are $2M Credit sales are $24 million Factor receivables at 2% discount What is the effective rate of interest? Receivables turnover = 24/2 = 12 times Ave. collection period = 365/12 = 30.4 days APR = (.02/.98) x 12 = .2449 or 24.49% EAR = (1+.02/.98)12 – 1 = .2743 or 27.43%

Example: Trade Credit Supplier offers terms of 2/10 net 30 LO5 Supplier offers terms of 2/10 net 30 What is the effective rate of interest? Suppose invoice is for $100 Can pay invoice on day 10 for $98 It costs $2 to borrow the $98 for 20 days APR = ($2/$98) (365/20) = .3724 or 37.24% EAR = (1+$2/$98)365/20 – 1 = .4459 or 44.59%

Trade Credit Formula LO5

Trade Credit Formula LO5

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 major forms of short-term borrowing?

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 The firm has several sources for short-term financing

© 2014 Dr. William F. Rentz & Associates Additions, deletions, and corrections to these transparencies were performed by Dr. William F. Rentz solely for use at the University of Ottawa. The above copyright notice applies to all changes made herein.