Short-Term Financial Planning Final chapter!

Key Concepts and Skills Be able to compute the operating and cash cycles and understand why they are important Understand the different types of short-term financial policy Understand the essentials of short-term financial planning

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

Sources and Uses of Cash Paying creditors or stockholders Decrease in long-term debt Decrease in equity Decrease in current liabilities Buying assets Increase in current assets Increase in fixed assets Sources of Cash Obtaining financing: Increase in long-term debt Increase in equity Increase in current liabilities 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 defined Inventory period Accounts receivable period

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

Table

Example Information Item Beginning Ending Average Inventory 200,000 300,000 250,000 Accounts Receivable 160,000 180,000 Accounts Payable 75,000 100,000 87,500 Net Sales = $1,150,000 Cost of Goods Sold = $820,000

Example - Operating Cycle Inventory Period Inventory Turnover IT = ? Inventory Period = ? Accounts Receivable Period Receivables Turnover RT = ? Receivables Period = ? Operating cycle

Example - Cash Cycle Accounts Payable Period Payables turnover PT = Accounts payables period = Cash cycle = So, we have to finance our inventory and receivables for ??? days

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

Carrying versus 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 Stock-out costs

Temporary versus Permanent Assets Are current assets temporary or permanent? Both! Permanent current assets = the level of current assets that the company retains regardless of any seasonality in sales Temporary current assets = the additional current assets that are added when sales are expected to increase on a seasonal basis

Figure 16.4

Choosing the Best Policy Best policy will be a combination of 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

Example

Cash Budget Primary tool in short-run financial planning Identify short-term needs and potential opportunities Identify when short-term financing may be required How it works Identify sales, cash collections and cash outflows Subtract outflows from inflows and determine investing and financing needs

Example: Cash Budget Information Expected Sales 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

Example: Cash Budget Information 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 with minimum cash balance of $2 m

Example: Cash Budget – Cash Collections Q1 Q2 Q3 Q4 Beginning Receivables 30 19 22 Sales 57 66 90 Cash Collections = Beg. Receivables + 2/3(Sales) 68 63 82 Ending Receivables = 1/3(Sales)

Example: Cash Budget – Cash Disbursements Q1 Q2 Q3 Q4 Payment of A/P = 50% of sales 28.50 33.00 45.00 Wages, taxes, other expenses 14.25 16.50 22.50 Capital Expenditures 35.00 Long-term financing (interest and dividends) 5.00 Total Disbursements 47.75 89.50 54.50 72.50

Example: Cash Budget – Net Cash Flow and Cash Balance Q1 Q2 Q3 Q4 Total Cash Collections 68.00 63.00 66.00 82.00 Total Cash Disbursements 47.75 89.50 54.50 72.50 Net Cash Flow 20.25 (26.50) 11.50 9.5 Beginning Cash Balance 5.00 25.25 (1.25) 10.25 Net Cash Inflow 9.50 Ending Cash Balance 19.75 Minimum Cash Balance -2.00 Cumulative surplus (deficit) 23.25 (3.25) 8.25 17.75

Short-Term Borrowing Unsecured loans Line of credit Committed Non-committed Revolving credit Secured loans – loan secured by receivables or inventory or both

Example: Factoring Selling receivables to someone else 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? Period rate = .025/.975 = 2.564% APR = 12(2.564%) = 30.769% What is the effective rate? EAR = 1.0256412 – 1 = 35.502%

Short-Term Financial Plan Q1 Q2 Q3 Q4 Beginning Cash 5.00 25.25 2.00 10.05 Net Cash Inflow 20.25 (26.50) 11.50 9.50 New Short-Term Debt 0.00 3.25 Interest on Short-Term Debt 0.20 Short-Term Debt Repayment Ending Cash Balance 19.55 Minimum Cash Balance -2.00 Cumulative Surplus (Deficit) 23.25 8.05 17.55 Beginning Short-Term Debt 000 Change in Short-Term Debt -3.25 Ending Short-Term Debt

Quick Quiz Suppose your average inventory is $10,000, your average receivables is $9,000 and your average payables is $4,000. Net sales are $100,000 and cost of goods sold is $50,000. What are the operating cycle and the cash cycle? What are the differences between flexible and restrictive short-term financial policies? What factors do we need to consider when choosing a financial policy? What factors go into determining a cash budget and why is it valuable?

End of the Semester! You made it!