1. Short-Term Finance and Planning18
Short-Term Finance and Planning
Prepared by Anne Inglis
Edited by William Rentz

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. Figure 18.1 – Cash Flow Time Line

9. 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

10. 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 = = 222 days

11. 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

12. 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

13. 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

14. Figure 18.2 – Carrying Costs and Storage Costs
LO2

15. Figure 18.2 – Carrying Costs and Storage Costs
LO2

16. 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

17. Figure 18.4 – Total Asset Requirement Over Time
LO2

18. 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

19. 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

20. 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

21. Figure 18.6 – A Compromise Financing Policy
LO2

22. 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

23. 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 = or 10.59%
NB. 9%/( ) = 10.59%
Note that this method of finding the effective rate only works if we are borrowing the money for one year.

24. 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 = or 24.49%
EAR = (1+.02/.98)12 – 1 = or 27.43%

25. 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) = or 37.24%
EAR = (1+$2/$98)365/20 – 1 = or 44.59%

26. Trade Credit Formula
LO5

27. Trade Credit Formula
LO5

28. 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?

29. 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

30. © 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.