1. Chapter 16
Short-Term
Financial
Planning

2. 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

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
Short-Term Borrowing
A Short-Term Financial Plan

4. Sources and Uses of Cash
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
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

5. 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

6. 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

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

8. 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
This is similar to the example in the book, just with a different number of zeros.
Net Sales = $1,150,000 Cost of Goods Sold = $820,000

9. Example - Operating Cycle
Inventory Period = 365 / Inventory Turnover
Inventory Turnover = COGS / Average inventory
IT = 820,000 / 250,000 = 3.28 times
Inventory Period = 365 / 3.28 = 111 days
Accounts Receivable Period = 365 / Receivables Turnover
Receivables Turnover = Credit Sales / Average AR
RT = 1,150,000 / 180,000 = 6.4 times
Receivables Period = 365 / 6.4 = 57 days
Operating cycle = = 168 days
Note that we are assuming that all sales are credit sales.
So, on average it takes 168 days from the time we receive the inventory to sell it and collect on the sale .

10. Example - Cash Cycle
Accounts Payables Period = 365 / payables turnover
Payables turnover = COGS / Average AP
PT = 820,000 / 87,500 = 9.4 times
Accounts payables period = 365 / 9.4 = 39 days
Cash cycle = 168 – 39 = 129 days
So, we have to finance our inventory and receivables for 129 days

11. 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
Point out that these two policies are the extremes. Most companies will be somewhere in between.
What are advantages and disadvantages of a flexible policy?
Advantages – you should not have difficulty meeting short-term obligations and you have cash on hand for emergencies or unexpected opportunities, lower shortage costs
Disadvantages – liquid securities generally do not offer as high a return as long-term assets (opportunity cost of liquidity), financing short-term assets with long-term debt can be dangerous if you run into an economic downturn (you sell less inventory and you may have too much on hand, accounts receivable defaults may increase and you still have to pay off long-term debt), high carrying costs
What are the advantages and disadvantages with the restrictive policy?
Advantages – Higher investment in long-term assets generally provides a higher return, lower carrying costs, short-term liabilities can be decreased more easily than long-term liabilities in the case of an economic downturn
Disadvantages – Less liquidity for emergencies or unexpected opportunities, higher shortage costs

12. 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 – 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

13. Temporary versus Permanent Assets
Are current assets temporary or permanent?
Both!
Permanent current assets refer to the level of current assets that the company retains regardless of any seasonality in sales
Temporary current assets refer to the additional current assets that are added when sales are expected to increase on a seasonal basis
A good example to help students see the difference between temporary and permanent assets is a discussion of retail stores and the different levels of inventory that they carry during the summer versus during the Christmas season.

14. Figure 16.4
Policy F always implies a short-term cash surplus and a large investment in cash and marketable securities.
Dollars
Policy F
Policy R
Long-term financing
Total asset requirement
Marketable securities
Time
Short-term financing
Policy R uses long-term financing for permanent asset requirements only and short-term borrowing for seasonal variations.

15. 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
Cash reserves
More important when a firm has unexpected opportunities on a regular basis or in areas where financial distress is a strong possibility
Less important in stable industries
Zero NPV investments at best and an excess of cash (and marketable securities) will hurt the firm’s return (investors are often very unhappy with excess cash reserves)
Maturity hedging
It may make sense to try and match liabilities to the maturity of the assets (how long you expect to require the assets)
Maturity matching would involve financing fixed assets and permanent current assets with long-term debt and temporary current assets with current liabilities
Avoid financing long-term assets with short-term securities – involves refinancing on a regular basis due to uncertainty of interest rates and may not be able to get refinancing if the firm runs into trouble
Relative interest rates
Long-term rates are normally (but not always) higher, therefore you don’t want to rely on higher interest debt to finance temporary short-term assets. The return on the short-term assets may not be enough to cover the cost of the debt.

16. Figure 16.5 Dollars Time Flexible policy (F) Compromise policy (C)
Restrictive policy (R)
Short-term financing
Total seasonal variation
Marketable securities
General growth in fixed assets and permanent current assets
With a compromise policy, 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.

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

18. Example: Cash Budget Information
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 with minimum cash balance of $2 million
ACP of 30 days implies that 2/3 of sales will be collected in quarter sold, 1/3 will be collected the following quarter
Payables period of 45 days implies that payables will be paid in the quarter the inventory is ordered

19. Example: Cash Budget – Cash CollectionsQ1 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)

20. Example: Cash Budget – Cash DisbursementsQ1 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

21. Example: Cash Budget – Net Cash Flow and Cash BalanceQ1 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
Based on these estimates the company will need to borrow money in the second quarter to help fund the capital expansion. Depending on the firm’s financial policy, it can borrow the funds either short-term or long-term. Given the cash surplus in Q3 and Q4, the firm would probably want to borrow on a short-term basis because their will be ample cash (assuming forecasts are reasonably accurate) in Q3 to repay the loan.

22. 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

23. 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%) = %
What is the effective rate?
EAR = – 1 = %
Factoring with a discount of 2.5% means that you sell the receivables for 97.5 cents on the dollar.
Factoring is often a relatively expensive form of financing. Ask the students the following questions to see if they see the relationship between the cost of financing and the various terms of the agreement:
Will the cost be higher or lower if the receivables are discounted at 3%? (higher: EAR = %)
Will the cost be higher or lower if the receivables turnover was 9? (lower: EAR = 25.59%)
The choice of the discount will often depend on the company’s receivables turnover – the longer it takes to collect on the receivables, the greater the risk to the purchaser of the receivables, the larger the discount will be.

24. Short-Term Financial PlanQ1 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
Assume that the interest rate on short-term debt is an APR of 24% (24/4 = 6% per quarter)
Technically the interest in Q3 is 3.25(.06) = It was rounded for presentation purposes.

25. Chapter 16 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 is 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?
Inventory turnover = 50,000 / 10,000 = 5 times
Inventory period = 365 / 5 = 73 days
Receivables turnover = 100,000 / 9,000 = times
Average collection period = 365 / = 33 days
Payables turnover = 50,000 / 4,000 = 12.5 times
Payables period = 365 / 12.5 = 29 days
Operating Cycle = = 106 days
Cash Cycle = 106 days – 29 days = 77 days