Short-Term Finance and Planning 13 Short-Term Finance and Planning

13.1 Working Capital Management

Working Capital Current, or short-term, assets and liabilities are collectively known as working capital. Net working capital = Current assets – Current liabilities

Working Capital Management Short-term financial Management = Working capital management Managing working capital is a daily activity that ensures that the firm has sufficient resources to continue its operations and avoid costly interruptions. Working capital management involves the administration, within policy guidelines, of current assets and current liabilities.

Cash and Net Working Capital Rearrange balance sheet identity Net working capital + Fixed assets = Long-term debt + Equity Net working capital = Cash + Other current assets – Current liabilities Cash = Long-term debt + Equity + Current liabilities – Current assets other than cash – Fixed assets Sources of cash Increasing long-term debt, equity, or current liabilities Decreasing current assets other than cash, or fixed assets Uses of cash Decreasing long-term debt, equity, or current liabilities Increasing current assets other than cash, or fixed assets

The Operating Cycle and the Cash Cycle

The Operating Cycle Operating cycle – the period from inventory purchase to the receipt of cash Inventory period – the period required to purchase and sell the inventory Accounts receivable period – the period required to collect on credit sales Operating cycle = Inventory period + Accounts receivable period

The Cash Cycle Cash cycle – the period from when cash is paid out to when is received. Accounts payable period – the period from inventory purchase to payment for the inventory Cash cycle = Operating cycle – Accounts payable period

Operating Cycle and Cash Cycle: Example Item Beginning Ending Inventory $2546 $2802 Accounts receivable 7564 6736 Accounts payable 3590 4050 Net sales $29500 Cost of goods sold 22750

Operating Cycle and Cash Cycle: Example Inventory turnover=$22750/[(2546+2802)/2]=8.51 times Inventory period=365 days/8.51times=42.89 days Receivable turnover=$29500/[(7564+6736)/2]=4.13 times Receivables period=365 days/4.13times = 88.38 days Payables turnover=$22750/[(3590+4050)/2]=5.96 times Payables period=365 days/5.96times = 61.24 days Operating cycle=42.89 days+88.38 days=131 days Cash cycle=131 days-61.24days=70 days Inventory has to be financed for 70 days.

Cash Flows and Working Capital Management The need for short-term financial management is suggested by the gap between cash inflows and cash outflows. The gap between cash inflows and cash outflows can be filled either by borrowing or by holding a liquidity reserve in the form of cash or marketable securities. The gap between cash inflows and cash outflows can be shortened by changing the inventory, receivable and payable periods.

13.2 Short-Term Financial Policy

Short-Term Financial Policy The 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 The financing of current assets Flexible policy – a low proportion of short-term debt relative to long-term financing. Restrictive policy – a high proportion of short-term debt relative to long-term financing.

The size of investments in current assets A flexible short-term financial policy Keeping large balances of cash and marketable securities. Making large investments in inventory. Granting liberal credit terms. A restrictive short-term finance policy Keeping low cash balances and making little investment in marketable securities. Making small investments in inventory. Allowing few or no credit sales.

Carrying Costs and Shortage Costs Increase with the level of investment in current assets Costs of maintaining economic value and opportunity costs Shortage costs Decrease with the level of investment in current assets Trading, or order, costs and costs related to lack of safety reserves Managing short-term assets involves a trade-off between carrying costs and shortage costs. A flexible policy is most appropriate when carrying costs are low relative to shortage costs. A restrictive policy is most appropriate when carrying costs are high relative to shortage costs.

The Optimal Investment in Current Assets

The Financing of Current Assets A flexible short-term financing policy A low proportion of short-term debt relative to long-term financing. A restrictive short-term financing policy A high proportion of short-term debt relative to long-term financing.

The Financing of Current Assets In an ideal economy, short-term assets can always be financed with short-term debt and long-term assets can always be financed with long-term debt. The net working capital is always zero. In a real economy, it is not likely that current assets will ever drop to zero. Firms generally need to carry a minimum level of “permanent” current assets at all times. A growing firm usually has a total asset requirement of current assets and current liabilities. The total asset may change because of (1) a general growth trend, (2) seasonal variation around the trend and (3) unpredictable day-to-day and month-to-month fluctuations.

The Financing of Current Assets A flexible policy has a short-term cash surplus and a large investment in cash and marketable securities. A restrictive policy uses long-term financing for permanent assets requirements only and short-term borrowing for seasonal variations. A compromise policy means 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.

The Best Financing Policy There is no definitive answer. Several considerations must be included in a proper analysis. Cash reserves Maturity hedging Relative interest Rates

13.3 Cash Budgeting

Cash Budgeting Cash Budgeting records estimates of cash inflows and outflows over a specified period. The result of cash budgeting is an estimate of the cash surplus or deficit. It is a primary tool in short-term financial planning It helps determine what borrowing is required or what lending will be possible in the short run.

Cash Budgeting: Example April May June Credit sales $390,000 $364,000 $438,000 Credit purchases 147,800 176,300 208,500 Cash disbursements Wages, taxes and expenses 53,800 51,000 78,300 Interest 13,100 Equipment purchases 87,000 147,000 Above are some important figures for the second quarter of the year. The company predicts that 5% of its credit sales will never be collected, 35% of its sales will be collected in the month of the sale, and the remaining 60% will be collected in the following month. Credit purchases will be paid in the month following the purchase. In march, credit sales were $245,000 and credit purchases were $168,000.

Cash Budgeting: Example April May June Beginning cash balance $140,000 $101,600 $104,100 Cash receipts Cash collections from credit sales 283,500 361,400 371,700 Total cash available $423,500 $463,000 $475,800 Cash disbursements Purchases $168,000 $147,800 $176,300 Wages, taxes and expenses 53,800 51,000 78,300 Interest 13,100 Equipment purchases 87,000 147,000 Total cash disbursements $321,900 $358,900 $267,700 Ending cash balance $208,100

13.4 Short-Term Borrowing

Short-Term Borrowing The most common way to finance a temporary cash deficit to arrange a short-term loan. Loans Unsecured loans Secured loans Other sources Commercial paper Trade Credit

Compensating Balance The company has a $100,000 line of credit with a 10% compensating balance requirement. The quoted interest rate is 16%. The company needs to borrow $54,000 for one year. How much do the company need to borrow? $54,000 / (1- 0.10) = $60,000 $60,000*16%=$9,600 $9,600/54,000=17.78%