0. Short-Term Finance and Planning
Chapter
Eighteen
Short-Term Finance and Planning

1. 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
A Short-Term Financial Plan
Short-Term Borrowing

2. Sources and Uses of Cash 18.1
Net Working Capital Management: management of the firm’s CA and CL. Will the firm have sufficient cash to pay its bills?
Balance sheet identity (rearranged)
Net working capital + fixed assets = long-term debt + equity
Net working capital = cash + other CA – CL
Cash = long-term debt + equity + current liabilities – current assets other than cash – fixed assets
Sources
Increasing long-term debt, equity or current liabilities
Decreasing current assets other than cash or fixed assets
Uses
Decreasing long-term debt, equity or current liabilities
Increasing current assets other than cash or fixed assets

3. The Operating Cycle 18.2
Operating cycle – time period between the acquisition of inventory and the collection of A/Rs
Inventory period – time required to purchase and sell the inventory
Accounts receivable period – time to collect on credit sales (time between sale of inventory and collection of A/R)
Operating cycle = inventory period + accounts receivable period

4. The Cash Cycle Cash cycle
time period for which we need to finance our inventory
Difference between when we receive cash from the sale and when we have to pay for the inventory
Time between the payment for inventory and the receipt of A/R
Accounts payable period – time between purchase of inventory and payment for the inventory
Cash cycle = Operating cycle – accounts payable period

5. Figure 18.1 – Cash Flow Time Line

6. Notes Inventory period = 365 / Inv. Turnover
= 365 (Avg. Inv.) / COGS
Receivables Collection Period = 365 / A/R Turnover
= 365 (Avg. A/R) / Credit Sales
Payables Deferral Period = 365 / Payables Turnover
= 365 (Avg. A/P) / COGS

7. Example Information Inventory: Accounts Receivable: Accounts Payable:
Beginning = 5000
Ending = 6000
Accounts Receivable:
Beginning = 4000
Ending = 5000
Accounts Payable:
Beginning = 2200
Ending = 3500
Net sales = 30,000 (assume all sales are on credit)
Cost of Goods sold = 12,000

8. Example – Operating Cycle
Inventory period
Average inventory = ( )/2 = 5500
Inventory turnover = 12,000 / 5500 = 2.18 times
Inventory period = 365 / 2.18 = 167 days
Receivables period
Average receivables = ( )/2 = 4500
Receivables turnover = 30,000/4500 = 6.67 times
Receivables period = 365 / 6.67 = 55 days
Operating cycle = = 222 days

9. Example – Cash Cycle Payables Period Cash Cycle = 222 – 87 = 135 days
Average payables = ( )/2 = 2850
Payables turnover = 12,000/2850 = 4.21 times
Payables period = 365 / 4.21 = 87 days
Cash Cycle = 222 – 87 = 135 days
We have to finance our inventory for 135 days
We need to be looking more carefully at our receivables and our payables periods – they both seem extensive

10. Short-Term Financial Policy 18.3
Size of investments in current assets
Flexible policy – maintain a high ratio of current assets to sales (hold a lot of CA i.e., very liquid & low profit)
Restrictive policy – maintain a low ratio of current assets to sales (hold few CA i.e., low liquidity & high profit)
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

11. Carrying vs. Shortage Costs
Managing short-term assets involves a trade-off between carrying costs and shortage costs
Carrying costs – increase with increased levels of current assets (eg. Interest), the costs to store and finance the assets
Shortage costs – decrease with increased levels of current assets, the costs to replenish assets
Trading or order costs & stock out costs
Costs related to safety reserves, i.e., lost sales, lost customers and production stoppages

12. Figure 18.2 – Carrying Costs and Shortage Costs

13. Figure 18.2 – Carrying Costs and Shortage Costs

14. Temporary vs. Permanent Assets
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 aren’t sold

15. Figure 18.4 – Total Asset Requirement Over Time

16. Total Asset Requirement Over Time (cont.)
Restrictive Policy- Short-term financing is used for seasonal CAs only (i.e., more interest rate risk & higher profit)
Flexible Policy- Finance all assets with long-term debt and equity (i.e., less interest rate risk & lower returns)
Compromise (Moderate) Policy- Finance all fixed assets, permanent CAs plus some seasonal CAs with long-term financing (i.e., moderates interest rate risk & profit)

17. Choosing the Best Policy
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
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

18. Choosing the Best Policy continued
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

19. Figure 18.6 – A Compromise Financing Policy

20. The Cash Budget 18.4
Cash Budget- examines all expected inflows and outflows of cash for a number of periods into the future
Forecast of cash inflows and outflows over the next short-term planning period
Primary tool in short-term financial planning
Helps determine when the firm should experience cash surpluses and when it will need to borrow to cover working-capital costs
Allows a company to plan ahead and begin the search for financing before the money is actually needed

21. Example: Cash Budget Information
It is December 1, A firm expects sales estimates over the next four months to be as follows:
December = $150,000, January = $60,000, February = $70,000, March = $75,000.
Sales in October and November were $80,000 and $100,000 respectively.
Twenty percent of these sales are cash, 30% are paid one month after sales, and 50 % are paid two months after sale. A 2% discount is given for accounts paid in the first month after sale.
The firm purchases inventory of 60% of next month’s expected sales for cash.

22. Example: Cash Budget Information (cont.)
Wages are $40,000 per month and depreciation is $10,000 per month.
Taxes of $80,000 will be paid in January.
The firm will sell $4,000 in stock in February.
Currently, $5,000 of cash is on hand. A minimum balance of $10,000 is required.
Complete a cash budget for December, January, and February.

23. Short-Term Borrowing 18.6
Line of Credit- a formal (committed) or informal (uncommitted) prearranged short-term bank loan letting the borrower borrow up to a specified amount over a specified period of time
Letter of credit- a written statement by a bank that money will be paid, provided conditions specified in the letter are met.
Covenants- a promise by the firm included, in the debt contract, to perform certain acts (e.g., restrictions of further debt and limits on dividends)
Secured loan- assets back the loan
Unsecured loan- no assets backing the loan
Inventory Loans- a secured short-term loan to purchase inventory.

24. Covenants Protective Covenants
Negative covenants – things the borrower agrees not to do
Agrees to limit the amount of dividends paid
Agree not to pledge assets to other lenders
Agree not to merge with, sell to or acquire another firm
Agree not to buy new capital assets above $x in value
Agree not to issue new debt
Positive covenants – things the borrower agrees to do
Maintain a minimum current ratio
Provide audited financial statements
Maintain collateral in good condition

25. Example: Compensating Balance
We have a $500,000 operating loan with a 15% compensating balance requirement. The quoted interest rate is 9%. We need to borrow $150,000 for inventory for one year.
Note: A Compensating Balance is some of the firm’s money kept by the bank in low-interest or no-interest bearing accounts. This will increase the effective interest rate earned by the bank, thereby compensating the bank.
How much do we 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%
Note that this method of finding the effective rate only works if we are borrowing the money for one year.

26. Factoring EAR = [ 1 + {discount / (1 – discount)}^(365/ACP) – 1
The A/Rs are sold at a discount and the borrower is not responsible for the default of the A/Rs (i.e., A/R financing)
A factor is an independent company that acts as “an outside credit department” for the client. It checks the credit of new customers, authorizes credit, handles collection and bookkeeping.
The legal arrangement is that the factor purchases the A/R from the firm. Thus, factoring provides insurance against bad debts because any defaults on bad accounts are the factor’s problem.

27. Example: Factoring
Last year your company had average accounts receivable of $2 million. Credit sales were $24 million. You factor receivables by discounting them 2%. What is the effective rate of interest?
A/R turnover ratio= 24/2 = 12 times
Average collection period = 365/12 = 30.4 days
EAR = (1+.02/.98)365/30.4 – 1 = or 27.43%