1. McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Short-Term Finance and Planning Chapter 26

2. 26-1 Key Concepts and Skills  Understand the components of the cash cycle and why it is important  Understand the pros and cons of the various short-term financing policies  Be able to prepare a cash budget  Understand the various options for short-term financing

3. 26-2 Chapter Outline 26.1 Tracing Cash and Net Working Capital 26.2 The Operating Cycle and the Cash Cycle 26.3 Some Aspects of Short-Term Financial Policy 26.4 Cash Budgeting 26.5 The Short-Term Financial Plan

4. 26-3 Balance Sheet Model of the Firm How much short- term cash flow does a company need to pay its bills? Net Working Capital Current Assets Fixed Assets 1. Tangible 2. Intangible Shareholders’ Equity Current Liabilities Long-Term Debt

5. 26-4 26.1 Tracing Cash and Net Working Capital  Current Assets are cash and other assets that are expected to be converted to cash within the year. Cash Marketable securities Accounts receivable Inventory  Current Liabilities are obligations that are expected to require cash payment within the year. Accounts payable Accrued wages Taxes

6. 26-5 Defining Cash in Terms of Other Elements Net Working Capital + Fixed Assets = Long- Term Debt +Equity Net Working Capital =Cash Other Current Assets Current Liabilities – +Cash= Long- Term Debt +Equity– Net Working Capital (excluding cash) Fixed Assets –

7. 26-6 Defining Cash in Terms of Other Elements  An increase in long-term debt and or equity leads to an increase in cash—as does a decrease in fixed assets or a decrease in the non-cash components of net working capital.  The sources and uses of cash follow from this reasoning. Cash= Long- Term Debt +Equity– Net Working Capital (excluding cash) Fixed Assets –

8. 26-7 26.2 The Operating Cycle and the Cash Cycle Time Accounts payable period Cash cycle Operating cycle Cash received Accounts receivable periodInventory period Finished goods sold Firm receives invoiceCash paid for materials Order Placed Stock Arrives Raw material purchased

9. 26-8 The Operating Cycle and the Cash Cycle  In practice, the inventory period, the accounts receivable period, and the accounts payable period are measured by days in inventory, days in receivables, and days in payables, respectively. Cash cycle=Operating cycle– Accounts payable period

10. 26-9 Example  Inventory: Beginning = 200,000 Ending = 300,000  Accounts Receivable: Beginning = 160,000 Ending = 200,000  Accounts Payable: Beginning = 75,000 Ending = 100,000  Net sales = 1,150,000  Cost of Goods sold = 820,000

11. 26-10 Example  Inventory period Average inventory = (200,000+300,000)/2 = 250,000 Inventory turnover = 820,000 / 250,000 = 3.28 times Inventory period = 365 / 3.28 = 111.3 days  Receivables period Average receivables = (160,000+200,000)/2 = 180,000 Receivables turnover = 1,150,000 / 180,000 = 6.39 times Receivables period = 365 / 6.39 = 57.1 days  Operating cycle = 111.3 + 57.1 = 168.4 days

12. 26-11 Example  Payables Period Average payables = (75,000+100,000)/2 = 87,500 Payables turnover = 820,000 / 87,500 = 9.37 times Payables period = 365 / 9.37 = 38.9 days  Cash Cycle = 168.4 – 38.9 = 129.5 days  We have to finance our inventory for 129.5 days.  If we want to reduce our financing needs, we need to look carefully at our receivables and inventory periods – they both seem excessive.

13. 26-12 26.3 Some Aspects of Short-Term Financial Policy  There are two elements of the policy that a firm adopts for short-term finance. The size of the firm’s investment in current assets, usually measured relative to the firm’s level of total operating revenues.  Flexible  Restrictive Alternative financing policies for current assets, usually measured as the proportion of short-term debt to long-term debt.  Flexible  Restrictive

14. 26-13 Size of Investment in Current Assets  A flexible short-term finance policy would maintain a high ratio of current assets to sales. Keeping large cash balances and investments in marketable securities Large investments in inventory Liberal credit terms  A restrictive short-term finance policy would maintain a low ratio of current assets to sales. Keeping low cash balances, no investment in marketable securities Making small investments in inventory Allowing no credit sales (thus no accounts receivable)

15. 26-14 Carrying Costs and Shortage Costs $ Investment in Current Assets ($) Shortage costs Carrying costs Total costs of holding current assets. CA * Minimum point

16. 26-15 Appropriate Flexible Policy $ Investment in Current Assets ($) Shortage costs Carrying costs Total costs of holding current assets. CA * Minimum point

17. 26-16 Appropriate Restrictive Policy $ Investment in Current Assets ($) Shortage costs Carrying costs Total costs of holding current assets. CA * Minimum point

18. 26-17 Alternative Financing Policies  A flexible short-term finance policy means a low proportion of short-term debt relative to long-term financing.  A restrictive short-term finance policy means a high proportion of short-term debt relative to long-term financing.  In an ideal world, short-term assets are always financed with short-term debt, and long-term assets are always financed with long-term debt. In this world, net working capital is zero.

19. 26-18 26.4 Cash Budgeting  A cash budget is a primary tool of short-run financial planning.  The idea is simple: Record the estimates of cash receipts and disbursements.  Cash Receipts Arise from sales, but we need to estimate when we actually collect  Cash Outflow Payments of Accounts Payable Wages, Taxes, and other Expenses Capital Expenditures Long-Term Financial Planning

20. 26-19 Example  Pet Treats Inc. specializes in gourmet pet treats and receives all income from sales  Sales estimates (in millions) Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550  Accounts receivable Beginning receivables = $250 Average collection period = 30 days  Accounts payable Purchases = 50% of next quarter’s sales Beginning payables = 125 Accounts payable period is 45 days  Other expenses Wages, taxes and other expense are 30% of sales Interest and dividend payments are $50 A major capital expenditure of $200 is expected in the second quarter  The initial cash balance is $80 and the company maintains a minimum balance of $50

21. 26-20 Example  ACP = 30 days, this implies that 2/3 of sales are collected in the quarter made, and the remaining 1/3 are collected the following quarter.  Beginning receivables of $250 will be collected in the first quarter. Q1Q2Q3Q4 Beginning Receivables250167200217 Sales500600650800 Cash Collections583567633750 Ending Receivables167200217267

22. 26-21 Example  Payables period is 45 days, so half of the purchases will be paid for each quarter, and the remaining will be paid the following quarter.  Beginning payables = $125 Q1Q2Q3Q4 Payment of accounts275313362338 Wages, taxes and other expenses150180195240 Capital expenditures200 Interest and dividend payments50 Total cash disbursements475743607628

23. 26-22 Example Q1Q2Q3Q4 Total cash collections583567633750 Total cash disbursements475743607628 Net cash inflow108-17626122 Beginning Cash Balance801881238 Net cash inflow108-17626122 Ending cash balance1881238160 Minimum cash balance-50 Cumulative surplus (deficit)138-39-12110

24. 26-23 26.5 The Short-Term Financial Plan  The most common way to finance a temporary cash deficit is to arrange a short-term loan.  Unsecured Loans Line of credit (at the bank)  Secured Loans Accounts receivable can be either assigned or factored. Inventory loans use inventory as collateral.  Other Sources Banker’s acceptance Commercial paper

25. 26-24 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 key components of a cash budget?  What are the major forms of short-term borrowing?