1. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Short-Term Financial Planning Chapter 16

2. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.1 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. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.2 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. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.3 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. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.4 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. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.5 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. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.6 Table 16.1

8. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.7 Example Information ItemBeginningEndingAverage Inventory200,000300,000250,000 Accounts Receivable 160,000200,000180,000 Accounts Payable 75,000100,00087,500 Net Sales = $1,150,000Cost of Goods Sold = $820,000

9. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.8 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 = 111 + 57 = 168 days

10. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.9 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. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.10 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

12. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.11 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. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.12 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

14. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.13 Figure 16.4

15. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.14 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

16. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.15 Figure 16.5

17. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.16 Cash Budget Primary tool in short-run financial planning 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. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.17 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

19. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.18 Example: Cash Budget – Cash Collections Q1Q2Q3Q4 Beginning Receivables301922 Sales5766 90 Cash Collections = Beg. Receivables + 2/3(Sales) 68636682 Ending Receivables = 1/3(Sales) 1922 30

20. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.19 Example: Cash Budget – Cash Disbursements Q1Q2Q3Q4 Payment of A/P = 50% of sales 28.5033.00 45.00 Wages, taxes, other expenses 14.2516.50 22.50 Capital Expenditures35.00 Long-term financing (interest and dividends) 5.00 Total Disbursements47.7589.5054.5072.50

21. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.20 Example: Cash Budget – Net Cash Flow and Cash Balance Q1Q2Q3Q4 Total Cash Collections68.0063.0066.0082.00 Total Cash Disbursements47.7589.5054.5072.50 Net Cash Flow20.25(26.50)11.509.5 Beginning Cash Balance5.0025.25(1.25)10.25 Net Cash Inflow20.25(26.50)11.509.50 Ending Cash Balance25.25(1.25)10.2519.75 Minimum Cash Balance-2.00 Cumulative surplus (deficit)23.25(3.25)8.2517.75

22. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.21 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. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.22 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%) = 30.769% What is the effective rate? EAR = 1.02564 12 – 1 = 35.502%

24. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.23 Short-Term Financial Plan Q1Q2Q3Q4 Beginning Cash5.0025.252.0010.05 Net Cash Inflow20.25(26.50)11.509.50 New Short-Term Debt0.003.250.00 Interest on Short-Term Debt0.00 0.200.00 Short-Term Debt Repayment0.00 3.250.00 Ending Cash Balance25.252.0010.0519.55 Minimum Cash Balance-2.00 Cumulative Surplus (Deficit)23.250.008.0517.55 Beginning Short-Term Debt0.000003.250.00 Change in Short-Term Debt0.003.25-3.250.00 Ending Short-Term Debt0.003.250.00

25. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.24 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?