Short-Term Finance and Planning

Chapter

Eighteen

Short-Term Finance and Planning

© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

18.1

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

Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.

18.2

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


18.3

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


18.4

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


18.5

Figure 18.1 – Cash Flow Time Line


18.6

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


18.7

Example Information

• Inventory:

– Beginning = 5000

– Ending = 6000

• Accounts Receivable:


– Ending = 5000

• Accounts Payable:


– Ending = 3500

• Net sales = 30,000 (assume all sales are on credit)

• Cost of Goods sold = 12,000


18.8

Example – Operating Cycle

• Inventory period

– Average inventory = (5000 + 6000)/2 = 5500

– Inventory turnover = 12,000 / 5500 = 2.18 times

– Inventory period = 365 / 2.18 = 167 days

• Receivables period

– Average receivables = (4000 + 5000)/2 = 4500

– Receivables turnover = 30,000/4500 = 6.67 times

– Receivables period = 365 / 6.67 = 55 days

• Operating cycle = 167 + 55 = 222 days


18.9

Example – Cash Cycle

• Payables Period

– Average payables = (2200 + 3500)/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


18.10

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 longterm debt


18.11

Carrying vs. Shortage Costs

• Managing short-term assets involves a tradeoff 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


18.12

Figure 18.2 – Carrying Costs and Shortage Costs


18.13

Figure 18.2 – Carrying Costs and Shortage Costs


18.14

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


18.15

Figure 18.4 – Total Asset Requirement Over Time


18.16

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)


18.17

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


18.18

Choosing the Best Policy continued

• Relative Interest Rates

– Short-term rates are normally lower than longterm 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


18.19

Figure 18.6 – A Compromise Financing Policy


18.20

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


18.21

Example: Cash Budget Information

• It is December 1, 2006. 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.


18.22

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.


18.23

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.


18.24

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


18.25

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 = .1059 or 10.59%


18.26

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.


18.27

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 = .2743 or 27.43%


Short-Term Finance and Planning

Chapter

Eighteen

Short-Term Finance and Planning

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