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Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Chapter 16

Short-Term Financial Planning

Short-Term Financial Planning

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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

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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

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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

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The Operating Cycle

• The time it takes to receive inventory, sell it, and collect on the receivables generated from the sale of the inventory

• 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

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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

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Table 16.1

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Example Information

Item Beginning Ending Average

Inventory 200,000 300,000 250,000

Accounts Receivable

160,000 200,000 180,000

Accounts Payable

75,000 100,000 87,500

Net Sales = $1,150,000 Cost of Goods Sold = $820,000

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Example: Operating Cycle• 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 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 days

• Operating cycle = 111 + 57 = 168 days

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Example: Cash Cycle• Accounts Payable 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

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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

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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

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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

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Figure 16.4

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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, and maintain a cash reserve for emergencies

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Figure 16.5

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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

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Example: Cash Budget Information• Expected Sales 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

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Example: Cash Budget – Cash Collections

Q1 Q2 Q3 Q4

Beginning Receivables 30 19 22 22

Sales 57 66 66 90

Cash Collections = Beg. Receivables + 2/3(Sales)

68 63 66 82

Ending Receivables = 1/3(Sales)

19 22 22 30

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Example: Cash Budget – Cash Disbursements

Q1 Q2 Q3 Q4

Payment of A/P = 50% of sales

28.50 33.00 33.00 45.00

Wages, taxes, other expenses

14.25 16.50 16.50 22.50

Capital Expenditures 35.00

Long-term financing (interest and dividends)

5.00 5.00 5.00 5.00

Total Disbursements 47.75 89.50 54.50 72.50

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Example: Cash Budget – NetCash 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 20.25 (26.50) 11.50 9.50

Ending Cash Balance 25.25 (1.25) 10.25 19.75

Minimum Cash Balance -2.00 -2.00 -2.00 -2.00

Cumulative surplus (deficit)

23.25 (3.25) 8.25 17.75

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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, inventory, or both

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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 = 1.0256412 – 1 = 35.502%

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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 0.00 0.00

Interest on Short-Term Debt 0.00 0.00 0.20 0.00

Short-Term Debt Repayment 0.00 0.00 3.25 0.00

Ending Cash Balance 25.25 2.00 10.05 19.55

Minimum Cash Balance -2.00 -2.00 -2.00 -2.00

Cumulative Surplus (Deficit) 23.25 0.00 8.05 17.55

Beginning Short-Term Debt 0.00 000 3.25 0.00

Change in Short-Term Debt 0.00 3.25 -3.25 0.00

Ending Short-Term Debt 0.00 3.25 0.00 0.00

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Quick Quiz• Suppose your average inventory is $10,000,

your average receivables balance is $9,000, and your average payables balance is $4,000. Net sales are $100,000 and cost of goods sold is $50,000.– What are 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?

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Comprehensive Problem

• With average accounts receivable of $5 million, and credit sales of $24 million, you factor receivables by discounting them 2%. What is the effective rate of interest?