Chapter 16
Short-Term
Financial Planning
0
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
1-116-1
Key Concepts and Skills
• Be able to compute the operating and
cash cycles and understand why they are
important
• Understand the different types of shortterm financial policy
• Understand the essentials of short-term
financial planning
1
1-216-2
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
2
1-316-3
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
3
1-416-4
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
4
1-516-5
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
5
1-616-6
Table 16.1
6
1-716-7
Example Information
Item
Beginning
Ending
Average
Inventory
200,000
300,000
250,000
Accounts
Receivable
160,000
200,000
180,000
75,000
100,000
87,500
Accounts
Payable
Net Sales = $1,150,000
Cost of Goods Sold = $820,000
7
1-816-8
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
8
1-916-9
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
9
1-10
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
10
1-11
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
11
1-12
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
12
1-13
16-13
Figure 16.4
13
1-14
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, and maintain a cash
reserve for emergencies
14
1-15
16-15
Figure 16.5
15
1-16
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
16
1-17
16-17
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
17
Example: Cash Budget – Cash
Collections
Q1
Q2
Q3
1-18
16-18
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
18
1-19
16-19
Example: Cash Budget – Cash
Disbursements
Payment of A/P = 50%
of sales
Wages, taxes, other
expenses
Capital Expenditures
Long-term financing
(interest and dividends)
Total Disbursements
Q1
Q2
Q3
28.50 33.00 33.00
Q4
45.00
14.25 16.50 16.50
22.50
35.00
5.00
5.00
5.00
5.00
47.75 89.50 54.50
72.50
19
Example: Cash Budget – Net
Cash Flow and Cash Balance
Q1
Q2
Q3
1-20
16-20
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
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
Beginning Cash Balance
20
1-21
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,
inventory, or both
21
1-22
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 = 1.0256412 – 1 = 35.502%
22
1-23
16-23
Short-Term Financial Plan
Q1
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
23
1-24
16-24
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?
24
1-25
16-25
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?
25