Ch. 16: Short-Term Financial Planning Cash and Net Working Capital The Operating Cycle and the Cash Cycle Short-Term Financial Policy The Cash Budget A Short-Term Financial Plan Short-Term Borrowing Factoring

Sources and Uses of Cash Sources of Cash From financing: Increase in long-term debt Increase in equity Increase in current liabilities From selling assets Decrease in current assets Decrease in fixed assets

The Operating Cycle The time it takes to receive inventory, sell it and collect on the receivables generated from the sale Operating cycle = inventory period + accounts receivable period Inventory period = time inventory sits on the shelf Accounts receivable period = time it takes to collect on receivables

The Cash Cycle The time between payment for inventory and receipt from the sale of inventory Cash cycle = operating cycle – accounts payable period Accounts payable period = time between receipt of inventory and payment for it The cash cycle measures how long we need to finance inventory and receivables

Table 16.1 Use this table as motivation for why non-finance majors need to understand short-term financial management

Example Given the following averages: Inventory = $2,500, Accounts Receivable = $1,800, Accounts Payable = $875, and given Net Sales (all on credit) = $11,500 and Cost of Goods Sold (all on credit) = $8,200, find Operating Cycle and Cash Cycle (in days)

Short-Term Financial Policy Flexible (Conservative) Policy Large amounts of cash & 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 & marketable security balances Low inventory levels Little or no credit sales (low accounts receivable) Relatively high levels of short-term liabilities Low liquidity

Policies Graphed See Fig. 16.4, p. 458 Permanent vs. temporary current assets Best policy will be in between flexible and restrictive policies Things to consider Cash reserves Maturity hedging Relative interest rates Compromise policy: borrow short-term to meet peak needs, maintain a cash reserve for emergencies

Carrying vs. Shortage Costs Carrying costs Opportunity cost of owning current assets versus long-term assets that pay higher returns Cost of storing larger amounts of inventory Shortage costs Order costs – the cost of ordering additional inventory or transferring cash Stock-out costs – the cost of lost sales due to lack of inventory, including lost customers

Cash Budget Example Expected Sales for 2000 by quarter (millions) Q1: $57; Q2: $66; Q3: $66; Q4: $90 Beginning Accounts Receivable = $30 Average collection period = 30 days Purchases from suppliers = 50% of next quarter’s estimated sales Accounts payable period = 45 days Wages, taxes and other expenses = 25% of sales Interest and dividends = $5 million per quarter Major expansion planned for Quarter 2 costing $35 million Beginning cash balance = $5 million Minimum cash balance = $2 million

Cash Budget

Short-Term Financial Plan

Short-Term Borrowing Unsecured loans Line of credit: prearranged agreement with a bank that allows the firm to borrow up to a certain amount on a short-term basis Committed: formal legal arrangement that may require a commitment fee and generally has a floating interest rate Non-committed: informal agreement with a bank that is similar to credit card debt for individuals Revolving credit: non-committed agreement with a longer time between evaluations Secured loans: loan secured by receivables or inventory or both

Factoring Selling receivables at a discount Example: You have an average of $1 million in receivables and you borrow money by factoring receivables with a discount of 2.5%. The receivables turnover is 12 times per year. What is the APR? Periodic rate = APR = What is the effective annual rate? EAR =

Recommended Practice Self-Test Problems 16.1 & 16.2, pp. 467-8 Problems on pp. 470-4: 5, 7, 9, 11, 13 (most answers are on p. 549)