0. Ch.26 Short-term finance and planning
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

1. Introduction
Current Liabilities
Current Assets
Net Working Capital
Long-Term Debt
How much short-term cash flow does a company need to pay its bills?
Fixed Assets
1. Tangible
2. Intangible
Shareholders’ Equity
Short term financing is to ensure that the firm does not run out of cash.
i.e. ensure that the firm has enough cash to pay its bills and makes sensible short-term borrowing and lending decisions.

2. Introduction Main difference between ST & LT: timing of cash flow:
ST: purchase raw materials and sell finished goods within one year
LT: purchases special machine running for 5 years.
ST financing is as important as capital structure and budgeting decision:
good working capital decisions can also have a major impact on firm value.

3. Outlines Introduction Tracing Cash and Net Working Capital
The Operating Cycle and the Cash Cycle
Some Aspects of Short-Term Financial Policy
Cash budgeting

4. Tracing Cash and Net Working Capital
Current Assets are cash and other assets that are expected to be converted to cash within the year.
Cash
Marketable securities
Accounts receivable
Inventory
Current Liabilities are obligations that are expected to require cash payment within the year.
Accounts payable
Expenses payable (Accrued wages, taxes)
Notes payable

5. Defining Cash in Terms of Other Elements
Net Working Capital +
Fixed Assets =
Long-Term Debt
Equity
Net Working Capital =
Cash
Other Current Assets
Current Liabilities – +
Cash =
Long-Term Debt +
Equity –
Other Current Assets
Fixed Assets
Current Liabilities

6. Defining Cash in Terms of Other Elements=
Long-Term Debt +
Equity –
Other Current Assets
Fixed Assets
Current Liabilities
An increase in long-term debt and or equity leads to an increase in cash—as does a decrease in fixed assets or a decrease in the non-cash components of net working capital (= Other current assets- Current liability).
The sources and uses of cash follow from this reasoning.

7. Sources of cash Sources of Cash : Activities that increase cash
Increase in long-term debt account (borrowed money)
Increase in equity accounts (sold stock)
Increase in current liability accounts (borrowed money)
Decrease in current asset accounts, other than cash (sold current assets)
Decrease in fixed assets (sold fixed assets)

8. Use of cash Uses of Cash: Activities that decrease cash
Decrease in long-term debt account (repaid loans)
Decrease in equity accounts (repurchased stock or paid dividends)
Decrease in current liability accounts (repaid suppliers or short-term creditors)
Increase in current asset accounts, other than cash (purchased current assets)
Increase in fixed assets (purchased fixed assets)

9. Tracing cash
Source of cash always involves increasing a liability (or equity) account or decreasing an asset account.
Use of cash involves decreasing liability by paying it off or increasing assets by purchasing something.
Is it a source or a use of cash?
Increasing in accounts payable by $100
Increasing in accounts receivable by $100
Accounts payable are what the firm own the suppliers, so it can be seen as a short-term debt. If it rises by $100, then the firm borrwoed money. It is a source of cash.
Accounts receivable suggests that the firm has loaned the money (an increase in short-term assets). So it is a use of cash.

10. The Operating Cycle and the Cash Cycle
Order Placed
Stock Arrives
Raw material purchased
Cash received
Finished goods sold
Inventory period
Accounts receivable period
Time
Accounts payable period
Operating cycle: the time we acquire some inventory to the time we collect the cash.– the time length it takes to acquire inventory, sell it and collect for it.
Inventory period: the time it takes to acquire and sell the inventory.
Account receivable period: the time it takes to collect on the sale.
Cash cycle: the time that pass before we collect the cash from sale, measured from when we actually pay for inventory.
Firm receives invoice
Cash paid for materials
Operating cycle
Cash cycle

11. Inventory period
The inventory period is the time to acquire and sell inventory.
Inventory turnover = Cost of goods sold / average inventory
Measures how fast we can sell products.
The higher the ratio, the more rapidly the firm turns over its inventory and hence the more efficiently are the firm managing its inventory.
Inventory period = inventory / daily COGS =365 / inventory turnover.
Note that the definition is different. Instead of using a “snapshot” value, picked from a point of time Balance sheet, it is better to use an average value to reduce the effect of the variation during the year.
Ex. Amazon.com: values more than Barnes and Noble, which has lager sales.
Its inventory period is 10 times per year = 4 times faster than Barnes and Noble.
The cash is received before it ships the inventory, or even fore it pays its inventory=> negative cash cycle!!
In 2007, its cash cycle is negative by 40 days. Receive the payment 40 days before it pays the book wholesellers.

12. Accounts receivable period
The accounts receivable period (average collection period) is the time to collect on the sale.
Receivables turnover = credit sales / average receivables
Measures how fast a firm collect on its sales.
Receivable period = receivables / daily sales = 365 / receivables turnover
The longer the receivables period, the longer the company should wait to receive their sales revenue.
credit sales:a sales transaction by which the buyer is allowed to take immediate possession of the purchased goods and pay for them at a later date.

13. Operating cycle
The operating cycle is the average time required to acquire inventory, sell it, and collect for it.
Operating cycle = inventory period + accounts receivable period.

14. Payables period
The accounts payable period is the time between receipt of inventory and payment
Payables turnover = Cost of goods sold / average payables
Payables period = 365 / payables turnover
The longer the payables period, the longer the company can delay the payment own to its customer.

15. The Cash Cycle and Operating cycle=
Operating cycle –
Accounts payable period
The operating cycle begins when inventory is purchased (receipt of goods), and the cash cycle begins with the payment of accounts payable.
In practice, the inventory period, the accounts receivable period, and the accounts payable period are measured by days in inventory, days in receivables, and days in payables, respectively.

16. Example--Compute the operating cycle and the cash cycle
Inventory:
Beginning = 200,000
Ending = 300,000
Accounts Receivable:
Beginning = 160,000
Ending = 200,000
Accounts Payable:
Beginning = 75,000
Ending = 100,000
Credit sales = 1,150,000
Cost of Goods sold = 820,000
Balance sheet information
Income statement information

17. Example Inventory period
Average inventory = (200, ,000)/2 = 250,000
Inventory turnover = 820,000 / 250,000 = 3.28 times
Spending $820K on inventory, which worth $250K each time.
Turned the inventory over 3.28 times during the year.
Or, buy and sell off the inventory 3.28 times during the year.
Inventory period = 365 / 3.28 = days
We held the inventory for days
Or , the inventory is stored about 111 days before it is sold.
Note: the values could be calculated using strictly ending values, rather than average values, for inventory, receivables, and payables.

18. Example Receivables period Operating cycle = 111.3 + 57.1 = 168.4 days
Average receivables = (160, ,000)/2 = 180,000
Receivables turnover = 1,150,000 / 180,000 = 6.39 times
Receive on average $180K, the total sales are $1.15b
Turn the receivables 6.4 times a year.
Receivables period = 365 / 6.39 = 57.1 days
Also called days’ sales in receivable or the average collection period.
The customer takes an average of 57 days to pay.
Operating cycle = = days
It takes on average 168 days per year to acquire inventory, sell it and collect for the sale.
Note: the values could be calculated using strictly ending values, rather than average values, for inventory, receivables, and payables.

19. Example Payables Period Cash Cycle = 168.4 – 38.9 = 129.5 days
Average payables = (75, ,000)/2 = 87,500
Payables turnover = 820,000 / 87,500 = 9.37 times
Payables period = 365 / 9.37 = 38.9 days
Hence the company takes an average of 39 days to pay the bills.
Cash Cycle = – 38.9 = days
We have to finance our inventory for days.
On average, there is a 129-day delay between the time to pay for the goods and the time to collect on the sale.

20. Interpreting the cash cycle
Cash cycle= inventory period + receivable period – payable period
Most firms have positive cash cycle (except Amazon)
The longer the cash cycle, the more financing is required.
The length of cash cycle can indicate whether the firm is having trouble moving inventory or collecting on receivables.
Cash cycle is linked to the firm’s profitability:
All other things being equal, the shorter the cash cycle is, the lower is the firm’s investment in inventories and receivables. The lower the firm’s total assets and the higher the total turnover.
However, this does not mean that long cash cycle is necessarily bad.
One of the basic determinants of profitability and growth for a firm is : total asset turn over= sales/ total assets.
The higher this ratio, the greater are the firm’s accounting return on assets (ROA) and return on equity ROE.

21. Cash cycle and industry features
Which industry may have a longer cash cycle?
Restaurants
Health care equipment
Which business may have a longer cash cycle?
Online selling
Retail store sells
Restaurant: the customer pays cash or use credit cards. E,g, receivables period of McDo is the longest in the industry: 14 days!
Perishable nature: short inventory period
Health care: longer operating cycle due to the longer receivable period. Most of these equipment are paid by the medical insurance companies and government medical insurance. The payment and arrangement of documents take time.
Apple and Dell: on line sales (negative cash cycle)
Hewlett-Packard: retail selling: larger inventory periods.

22. Some Aspects of Short-Term Financial Policy
There are two elements of the policy that a firm adopts for short-term finance.
The size of the firm’s investment in current assets, usually measured as the current asset relative to the firm’s level of total operating revenues.
The financing of current assets, usually measured as the proportion of short-term debt to long-term debt.
Two views of ST financing policy:
Flexible policy: high CA/Sales, Low ST debt/LT debt.
Restrictive policy: Low CA/Sales, High ST/LT debt.

23. Size of Investment in Current Assets
A flexible short-term finance policy would maintain a high ratio of current assets to sales.
Keeping large cash balances and investments in marketable securities
Large investments in inventory
Liberal credit terms
A restrictive short-term finance policy would maintain a low ratio of current assets to sales.
Keeping low cash balances, no investment in marketable securities
Making small investments in inventory
Allowing no credit sales (thus no accounts receivable)
Which one is better?
Flexible policy is costly: need cash to finance marketable securities, inventory, accounts receivables.
But it deserves a future cash inflows: with credit policy, the firm attract more customers.
With more inventory, it provides a quick delivery to customers and increases sales.
The firm can charge higher for better delivery service and credit payment.

24. Carrying costs and shortage costs
Carrying costs – costs that increase with investment in current assets
Opportunity cost of investing (and financing) other assets which may generate higher yield.
Cost associated with storing inventory, eg. warehouse
Shortage costs – costs that decrease with investment in current assets
Trading and order costs – commissions, set-up and paperwork
Stock-out costs – lost sales, alienated customers
Which policy involves a high carrying cost/ shortage cost?

25. Flexible or restrictive policy
Which policy involves a high carrying cost/ shortage cost?
Flexible (conservative) policy : Keep large amounts of inventory (higher carrying costs, but lower shortage costs including lost customers due to stock-outs)
Restrictive (aggressive) policy: high shortage costs, lower carrying costs, particularly bad in industries where there are plenty of close substitutes that customers can turn to.

26. Carrying Costs and Shortage Costs
Total costs of holding current assets. $
Minimum point
Shortage costs
Carrying costs
CA*
Investment in Current Assets ($)

27. Appropriate Flexible Policy$
Shortage costs
Carrying costs
Minimum point
Total costs of holding current assets.
CA*
Investment in Current Assets ($)

28. Appropriate Restrictive Policy
Minimum point $
Total costs of holding current assets.
Shortage costs
Carrying costs
CA*
Investment in Current Assets ($)

29. ST debt vs. LT debt
In an ideal world, short-term assets are always financed with short-term debt, and long-term assets are always financed with long-term debt.
In this world, net working capital is zero.
A flexible short-term finance policy means a low proportion of short-term debt relative to long-term financing.
A restrictive short-term finance policy means a high proportion of short-term debt relative to long-term financing.

30. Financing the current assets
A flexible policy
A restrictive policy

31. Which one is the best?
January
February
March
April
Current Assets
20,000
30,000
Fixed Assets
50,000
Permanent Assets
70,000
Temporary Assets
10,000
Flexible policy: finance $80,000 with long-term debt and have excess cash of $10,000 to invest in marketable securities
Restrictive policy: finance $70,000 with long-term debt. In February, the firm would borrow $10,000 on a short-term basis to cover the cost of temporary assets in that month.

32. Which one is the best? No definitive answer: some consideration
Plenty of cash (Flexible policy)
Reducing prob of financial distress. Don’t worry about the short term obligation.  
Maturity hedging
avoid financing long-term assets with short-term liabilities (risky due to possibility of increase in rates and the risk of not being able to refinance)
Relative interest rates
Short-term rates are usually lower than long-term;
But they are almost always more volatile.

33. Cash Budgeting
A cash budget is a primary tool of short-run financial planning.
The cash balance tells the manager what borrowing is required or what lending will be possible in the short run.
The idea is simple: Record the estimates of cash receipts and disbursements:
Steps to prepare a cash budget
Forecast the cash receipts
Forecast the cash disbursements
Calculate whether the firm is facing a cash shortage or surplus
The cash balance tells the manager what borrowing is required or what lending will be possible in the short run.

34. Cash Budgeting Cash Receipts: cash inflow (sources of cash)
Arise from sales, but cash comes later from collections on accounts receivables. We need to estimate when we actually collect.
Cash disbursement : cash outflow (uses of cash)
Payments of Accounts Payable
Wages, Taxes, and other Expenses
Capital Expenditures
Long-Term Financial Planning
The cash balance tells the manager what borrowing is required or what lending will be possible in the short run.

35. Example
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 30% 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 $80 and the company maintains a minimum balance of $50

36. Example– cash receipt Sales forecast for the next year by quarter: Q1
500
600
650
800
Cash Receipts: Accounts receivable
Beginning receivables = $250
Average collection period = 30 days
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.

37. Example – cash receipt Q1 Q2 Q3 Q4 a. Beginning Receivables 250 167
200
217
b. Sales
500
600
650
800
c. Collections
sales in current period (2/3)
333
400
433
533
sales in last period (1/3)
total cash collections
583
567
633
750
d.Ending Receivables (a+b-c)
267

38. Example –cash disbursement
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 , last period Q1 Q2 Q3 Q4 Q5
a. Sales
500
600
650
800
550
b. Purchases (1/2 sales)
300
325
400
275
previous period purchase (1/2)
125
150
163
200
138
current period purchase (1/2)
Total payment of accounts
313
362
338
Payment of accounts:
Q1: (600)/2 = 275
Q2: (650)/2 = 313 (rounded to nearest dollar throughout)
Q3: (800)/2 = 362
Q4: (550)/2 = 338

39. Example –cash disbursementQ1 Q2 Q3 Q4
Payment of accounts
275
313
362
338
Wages, taxes and other expenses
150
180
195
240
Capital expenditures
200
Interest and dividend payments 50
Total cash disbursements
475
743
607
628
Payment of accounts:
Q1: (600)/2 = 275
Q2: (650)/2 = 313 (rounded to nearest dollar throughout)
Q3: (800)/2 = 362
Q4: (550)/2 = 338

40. Example Q1 Q2 Q3 Q4 a. Total cash collections 583 567 633 750
b. Total cash disbursements
475
743
607
628
c. Net cash inflow (a-b)
108
-176 26
122
d.Beginning Cash Balance 80
188 12 38
e. Net cash inflow (c.)
f. Ending cash balance (d+e)
160
g. Minimum cash balance
-50
h. Cumulative surplus (deficit) (f+g)
138
-39
-12
110
The company will need to access a line of credit or borrow short-term to pay for the short-fall in quarter 2, but should be able to clear up the line of credit in quarter 4.
You could also use 50 as the beginning cash balance in quarters following deficits. This would assume funds were borrowed to achieve the target cash balance.

41. The Short-Term Financial Plan
The most common way to finance a temporary cash deficit is to arrange a short-term loan.
Unsecured Loans
Line of credit (at the bank) (commitment/ non commitmment)
Secured Loans
Accounts receivable can be either assigned or factored.
Inventory loans use inventory as collateral.
Other Sources
Commercial paper
Stretching payables
Line of credit – formal or informal prearranged short-term loans
Commitment loan: Commitment fee – charge to secure a committed line of credit
Non commitment loan: Compensating balance – deposit in a low (or no)-interest account as part of a loan agreement
Cost of a compensating balance – if the compensating balance requirement is on the used portion, less money than what is borrowed is actually available for use. If it is on the unused portion, the requirement becomes a commitment fee.
Accounts Receivable Financing
Assigning receivables – receivables are security for a loan, but the borrower retains the risk of uncollected receivables
Factoring – receivables are sold at a discount
Inventory Loans
Blanket inventory lien – all inventory acts as security for the loan
Trust receipt – borrower holds specific inventory in trust for the lender (e.g., automobile dealer financing)
Field warehouse financing – public warehouse acts as a control agent to supervise inventory for the lender
Commercial paper – short-term publicly traded loans, provided by other large companies plenty of cash.
Stretching payables: for the ability of firms to delay their payments in form of the payable accounts. However it is costly.In case of delay, the firm may pay more to their customers.