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Short-Term Financial Planning

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Presentation on theme: "Short-Term Financial Planning"— Presentation transcript:

1 Short-Term Financial Planning
Chapter 16

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

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

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 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)

20 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

21 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 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 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 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 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


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