Chapter 27
Financial Planning and Short-Term
Finance
Slides Prepared By:
Larbi Hammami
Desautels Faculty of Management
McGill University
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Executive Summary
• We are solidly into the third great question of corporate
finance.
– How much short-term cash flow does a company need
to pay its bills?
• This chapter introduces the basic elements of short-term
financial decisions. It:
– describes the short-term operating activities of the firm.
– identifies alternative short-term financial policies.
– outlines the basic elements in a short-term financial
plan.
– describes short-term financing instruments.
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Chapter Outline
27.1 Tracing Cash and Net Working Capital
27.2 Defining Cash in Terms of Other Elements
27.3 The Operating Cycle and the Cash Cycle
27.4 Some Aspects of Short-Term Financial
Policy
27.5 Cash Budgeting
27.6 The Short-Term Financial Plan
27.7 Summary & Conclusions
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27.1 Tracing Cash and Net Working
Capital
The Balance-Sheet Model of the Firm
Current
Liabilities
Current
Assets
The Capital
Budgeting Decision:
Capital
Assets
1. Tangible
2. Intangible
What long-term
investments
should the firm
engage in?
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Long-Term
Debt
Shareholders’
Equity
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27.1 Tracing Cash and Net Working
Capital
The Balance-Sheet Model of the Firm (cont.)
Current
Assets
Capital
Assets
1. Tangible
The Capital
Structure
Decision:
How can the
firm raise the
money for the
required
investments?
Current
Liabilities
Long-Term
Debt
Shareholder
s’ Equity
2. Intangible
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27.1 Tracing Cash and Net Working
Capital
The Balance-Sheet Model of the Firm (cont.)
Current
Assets
Capital
Assets
1 Tangible
2 Intangible
The Net Working Capital
Investment Decision:
Net
Working
Capital
How much
short-term
cash flow does
a company
need to pay its
bills?
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Current
Liabilities
Long-Term
Debt
Shareholder
s’ Equity
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27.1 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
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27.2 Defining Cash in Terms of Other
Elements
Net Working
Capital
Net Working
Capital
Fixed
+ Assets
= Cash
=
LongTerm +
Debt
Equity
Other Current
Current
+ Assets – Liabilities
LongNet Working
Capital
–
Cash = Term + Equity –
Debt
(excluding cash)
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Fixed
Assets
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27.2 Defining Cash in Terms of Other
Elements
LongNet Working
Fixed
Term
Capital
Cash =
+ Equity –
– Assets
Debt
(excluding cash)
• An increase in long-term debt and or equity leads to an
increase in cash - as does a decrease in capital assets or
a decrease in the non-cash components of net working
capital.
• The sources and uses of cash on the statement of cash
flows follows from this reasoning.
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27.3 The Operating Cycle and the Cash
Cycle
Raw material
purchased
Figure 27.1
Cash
received
Finished goods sold
Order Stock
Placed Arrives
Inventory period
Accounts receivable
period
Time
Accounts payable
period
Cash paid for materials
Firm receives invoice
Operating cycle
Cash cycle
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27.3 The Operating Cycle and the Cash
Cycle
Accounts
Cash cycle = Operating cycle – payable
period
• 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.
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27.3 The Operating Cycle and the Cash
Cycle
Example
• Consider the statement of financial position and the
income statement for Tradewinds Manufacturing shown in
Table 27.1 in the textbook.
• The operating cycle and the cash cycle can be determined
for Tradewinds after calculating the appropriate ratios for
inventory, receivables, and payables.
Cost of goods sold $8.2 million
Inventory turnover ratio =
=
= 3.3
Average inventory $2.5 million
365
Days in inventory =
= 110.6 days
3.3
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27.3 The Operating Cycle and the Cash
Cycle
Example (cont.)
Credit sales
Receivables turnover =
Average receivables
$11.5 million
=
= 6.4
$1.8 million
365
Days in receivables =
= 57 days.
6.4
Cost of goods sold
Accounts payable deferral perio =
Average payables
$8.2 million
=
= 9.4
$0.875
million
365
Days in payables =
= 38.8 days
9.4
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27.3 The Operating Cycle and the Cash
Cycle
Example (cont.)
• Operating cycle = Days in inventory + Days in receivables
= 110.6 days + 57 days
= 167.6 days
• Cash cycle = Operating cycle – Days in payable
= 167.6 days – 38.8 days = 128.8 days
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27.3 The Operating Cycle and the Cash
Cycle
Interpreting the Cash Cycle
• The cash cycle increases as the inventory and receivables
periods get longer.
• The cash cycle decreases if the company is able to stall
payment of payables by lengthening the payables period.
• If the cash cycle is positive, then the company may require
additional financing.
– The longer the cash cycle, the more financing is
required.
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27.3 The Operating Cycle and the Cash
Cycle
Interpreting the Cash Cycle (cont.)
• The cash cycle is related to profitability and sustainable
growth.
– A long cash cycle implies more assets tied up in
receivables and inventories which means the firm is less
efficient and less profitable.
– More financial resources must be diverted into financing
the higher balances of receivables and inventories.
– Increased inventories and receivables may also reduce
total asset turnover resulting in lower profitability.
• The total asset turnover is directly linked to sustainable
growth: reducing total asset turnover lowers sustainable
growth.
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27.4 Some Aspects of Short-Term
Financial Policy
• The firm’s short-term financial policy is comprised of two
elements:
1. The size of the firm’s investment in current assets
• Usually measured relative to the firm’s level of total
operating revenues.
– Flexible
– Restrictive
2. Alternative financing policies for current assets
• Usually measured as the proportion of short-term
debt to long-term debt.
– Flexible
– Restrictive
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27.4 Some Aspects of Short-Term
Financial Policy
The Size of the Investment in Current Assets
• A flexible short-term financial policy would maintain a high
ratio of current assets to sales.
– Keep large cash balances and investments in
marketable securities.
– Have large investments in inventory.
– Grant liberal credit terms.
• A restrictive short-term financial policy would maintain a
low ratio of current assets to sales.
– Keep low cash balances; no investment in marketable
securities.
– Make small investments in inventory.
– Allow no credit sales (thus no accounts receivable).
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27.4 Some Aspects of Short-Term
Financial Policy
The Size of the Investment in Current Assets (cont.)
• Managing current assets is a trade-off between carrying
costs and shortage costs.
• Carrying costs - 2 types:
– Opportunity costs since the rate of return on current
assets is low compared with that of other assets.
– Costs of maintaining the economic value of the item i.e.
warehousing or storage costs.
• Shortage costs - 2 types:
– Trading or order costs - costs of placing the orders for
more cash (brokerage fees) or inventories.
– Costs related to safety reserves - costs of lost
customers, lost goodwill and disruption of production.
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27.4 Some Aspects of Short-Term
Financial Policy
Figure 27.4: Carrying Costs and Shortage Costs
Total costs of holding
$
Minimum
current assets
Carrying
point
costs
Shortage
costs
CA*
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Investment in
Current Assets ($)
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27.4 Some Aspects of Short-Term
Financial Policy
Figure 27.4: Appropriate Flexible Policy
$
Minimum
point
Total costs of
holding current
assets
Carrying
costs
Shortage costs
CA*
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Investment in
Current Assets ($)
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27.4 Some Aspects of Short-Term
Financial Policy
Figure 27.4: When a Restrictive Policy Is Appropriate
Total costs of holding
Minimum current assets
$
point
Carrying costs
Shortage
costs
CA*
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Investment in
Current Assets ($)
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27.4 Some Aspects of Short-Term
Financial Policy
Alternative Financing Policies for Current Assets
• A flexible short-term finance policy means low proportion
of short-term debt relative to long-term financing.
• A restrictive short-term finance policy means 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 always zero.
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27.4 Some Aspects of Short-Term
Financial Policy
Figure 27.5: Financing Policy for an Idealized Economy
Current assets =
$ Short-term debt
Long-term
debt plus
common
stock
Fixed assets:
a growing firm
Time
0
1
2
3
4
5
Grain elevator operator buys crops after harvest, stores
them, and sells them during the year. Inventory is financed
with short-term debt. Net working capital is always zero.
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27.4 Some Aspects of Short-Term
Financial Policy
$
Total Asset
Requirement
Total Asset
Requirement
$
Marketable
Securities
Short Term
Financing
Long Term
Financing
Long Term
Financing
Time
Time
Figure 27.7: Alternative Asset-Financing Strategies
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27.4 Some Aspects of Short-Term
Financial Policy
Which Is Better?
1. Cash reserves. The flexible financing strategy requires cash
reserves.
– Reduce the probability of financial distress, but
– Are zero net present value, at best.
2. Maturity hedging. Most firms finance inventories with shortterm debt and capital assets with long-term debt. If mismatch
and finance long-term assets with short-term debt,
refinancing risk is increased.
3. Term structure. Short-term rates are normally lower than
long-term rates.
– More costly to rely on long-term borrowing
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27.4 Some Aspects of Short-Term
Financial Policy
A Remark on Short-Term Financing
• Maturity mismatching produces rollover risk, the risk that
reduced short-term financing may not be available.
• An example is the financial distress faced in 1992 by Olympia
and York (O and Y), a real estate development firm.
– O and Y’s main assets were office towers.
– Financing for these long-term assets was short-term bank
loans and commercial paper.
– In 1992, investor fears about real estate prospects
prevented O and Y from rolling over its commercial paper.
– The crises pushed O and Y into financial crisis and
bankruptcy.
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27.4 Some Aspects of Short-Term
Financial Policy
Current Assets and Liabilities in Practice
• Advances in technology are changing the way firms
manage their assets.
– Examples: just-in-time inventory and business-tobusiness (B2B) sales
– As a result, industrial firms are moving away from
flexible policies and toward a more restrictive approach
to current assets.
• Current liabilities are also declining as a percentage of
total assets.
– Firms are practicing maturity hedging as they match
lower current liabilities with decreased current assets.
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27.5 Cash Budgeting
• A cash budget is a primary tool of short-run financial
planning.
– The idea is simple: it records the estimates of cash
receipts and disbursements.
• Cash Receipts
– Arise from sales, but need to estimate actual collections
(collection period)
• Cash Outflow
1. Payments of Accounts Payable (payable period)
2. Wages, Taxes, and other Expenses
3. Capital Expenditures
4. Long-Term Financial Planning: payments of interest and
principal and dividends
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27.5 Cash Budgeting
• The cash balance tells the manager what borrowing is
required or what investing will be possible in the short run.
• The cash balance figures for Fun Toys appear in Table
27.6 in the textbook.
• Fun Toys had established a minimum cash balance of $5
million to facilitate transactions and to protect against
unexpected contingencies.
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27.6 The Short-Term Financial Plan
Short-Term Planning and Risk
• There are tools for assessing the degree of forecasting
risks and identifying their components that are most critical
to a financial plan’s success or failure.
• For example, Air Canada uses simulation analysis in
forecasting its cash needs. The simulation is useful in
capturing the variability of cash flow components in
Canada’s airline industry.
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27.6 The Short-Term Financial Plan
Example
– Chapters Online’s internet division sold books, CDROMs, DVDs, and videos through its website.
– In September 1999, the company went public, raising
equity at an offering price of $13.5/share.
– In August 2000, analysts calculated Chapters Online’s
“burn rate,” the rate at which the firm was using cash, to
determine its cash position.
– The stock price had fallen from the offering price of
$13.5 to $2.80 per share within a year.
– Analysts focused on the availability of short-term
borrowing to improve the firm’s financial position.
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27.6 The Short-Term Financial Plan
Example (cont.)
• The most common way to finance a temporary cash deficit
is to arrange a short-term, operating loan.
• Operating loans can be either unsecured or secured by
collateral.
• Secured Loans
– Accounts receivable financing can be either assigned or
factored.
– Securitized receivables, is a new approach to
receivables financing. For example, Sears Canada Ltd.
sold its receivables to Sears Canada Receivables Trust
(SCRT). SCRT issued debentures and commercial
paper backed by a diversified portfolio of receivables.
– Inventory loans use inventory as collateral.
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27.6 The Short-Term Financial Plan
Example (cont.)
• Other Sources
– Commercial paper
• Commercial paper: consists of short-term notes issued by
large and highly rated firms.
• Firms issuing commercial paper in Canada generally have
borrowing needs over $20 million.
• Dominion Bond Rating Service rates commercial paper similarly
to bonds.
– Banker’s acceptances
• Banker’s acceptances are a variant of commercial paper.
• Banker’s acceptances are more widely used than commercial
paper in Canada because Canadian chartered banks enjoy
stronger credit ratings than all but the largest corporations.
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27.6 The Short-Term Financial Plan
In the absence of short-term borrowing
• Without short-term financing, otherwise solvent businesses
would not have the liquid assets needed for current
obligations, like paying employee wages or repaying a loan.
This was the global environment all businesses faced in the
financial crisis of 2007-09 .
• Without short-term borrowing, operating is virtually
impossible. The central banks emphasis on lowering shortterm borrowing rates indicates the importance of this liquidity.
• The financial crisis in 2007-2008 demonstrated what could
happen when this liquidity was no longer available in the
market.
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27.7 Summary & Conclusions
• This chapter introduces the management of short-term
finance.
– We examine the short-term uses and sources of cash
as they appear on the firm’s financial statements.
– We see how current assets and current liabilities arise
in the short-term operating activities and the cash cycle
of the firm.
– From an accounting perspective, short-term finance
involves net working capital.
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27.7 Summary & Conclusions
• Managing short-term cash flows involves the minimization
of costs.
• The two major costs are:
– Carrying costs - the interest and related costs incurred
by overinvesting in short-term assets such as cash.
– Shortage costs - the cost of running out of short-term
assets.
• The objective of managing short-term finance and shortterm financial planning is to find the optimal tradeoff
between these two costs.
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27.7 Summary & Conclusions
• In an ideal economy, the firm could perfectly predict its
short-term uses and sources of cash and net working
capital could be kept at zero.
– In the real world, net working capital provides a buffer
that lets the firm meet its ongoing obligations.
• The financial manager seeks the optimal level of each of
the current assets.
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27.7 Summary & Conclusions
• The financial manager can use the cash budget to identify
short-term financial needs.
– The cash budget tells the manager what borrowing is
required or what lending will be possible in the short
run.
• The firm has available to it a number of possible ways of
acquiring funds to meet short-term shortfalls, including
unsecured and secured loans.
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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?
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