LOS 10
Management of Short-Term
Liabilities
Learning Outcome Statement (LOS)
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understand why we need to use short-term
financing
why use short-term financing
identify the sources of short-term financing
understand cash budgeting
summary and conclusion
Introduction
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Accounts payable is the Cinderella of the working capital
world.
While her more glamorous sister functions demand the bulk of
a company’s time and attention, accounts payable often lacks
the care and attention it deserves.
That’s a pity - because this Cinderella can account for about
60 percent of a company’s turnover. And when she is dressed
up to go to the ball, the results are immediate and can be
simply stunning.
Introduction
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A payable balance is the result of a company’s need or desire
to buy a service, a product, or a commodity.
Purchases can be divided into direct purchases (goods and
raw materials) or indirect purchases (pens, stationery, and
building maintenance and infrastructure costs, for example).
A/P Management – Why Need the
Attention?
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Even a small improvement to the accounts payable element of
working capital and the cost of purchases can deliver quick
results to the bottom line, often well out of proportion to the
amounts involved. These improvements can be broadly
equivalent to a significant boost in a company’s sales.
For a company facing the reality of static or declining sales,
this can spell the difference between collapse and survival, by
buying the time needed for rethinking and restructuring.
For a company managing growth, the return will be even
healthier key figures than would otherwise be the case.
A/P Management – Why Need the
Attention?
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As a broad rule of thumb, we would expect the cost of direct
purchases to fall by 3 to 5 percent, meaning that for every $1
billion of purchases, $30–$50 million would feed straight
through to the bottom line.
A company with a gross margin of 15 percent would need to
increase sales by $500 million to generate that much extra net
cash.
An increase in creditor days by 15 to 30 percent is also often
achieved, giving a further boost to working capital.
Objectives of Current Liabilities
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The structure of a firm’s current liabilities should achieve two
goals, such as
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It should provide the necessary amounts of short-term
financing
It should be in keeping with the target level of aggregate
liquidity.
The challenge in the management of current liabilities is to
achieve these goals at a minimum cost.
The Balance-Sheet Model of the Firm
The Capital Budgeting Decision
Current
Liabilities
Current Assets
Long-Term Debt
Fixed Assets
1 Tangible
2 Intangible
What long-term
investments
should the firm
engage in?
Shareholders’
Equity
The Balance-Sheet Model of the Firm
The Capital Structure Decision
Current
Liabilities
Current Assets
Long-Term Debt
Fixed Assets
1 Tangible
2 Intangible
How can the firm
raise the money
for the required
investments?
Shareholders’
Equity
The Balance-Sheet Model of the Firm
The Net Working Capital Investment Decision
Current
Liabilities
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Net
Working
Capital
How much shortterm cash flow
does a company
need to pay its
bills?
Long-Term Debt
Shareholders’
Equity
Types of Short-Term Financing
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Short-term financing is a liability that originally scheduled for
repayment within one year.
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Short-term financing can be classified as temporary shortterm financing and permanent short-term financing.
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Temporary short-term financing is used to provide
funds for transient cash flow shortages, such as those
caused by seasonality in sales. When it is cheaper to
borrow funds to cover such deficits than to keep a reserve
of funds against them, temporary borrowings are attractive
to the firm.
Permanent short-term financing are used by firms on
a continuing basis and are refinanced with new short-term
debt as they mature.
Some Aspects of Short-Term Financial
Policy
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There are two elements of the policy that a firm adopts for
short-term finance.
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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
The Size of the Investment in Current
Assets
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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).
Carrying Costs and Shortage Costs
$
Minimum
point
Total costs of holding current assets
Carrying costs
Shortage costs
CA*
Investment in
Current Assets ($)
Appropriate Flexible Policy
Total costs of holding current assets
$
Minimum
point
Carrying costs
Shortage costs
CA*
Investment in
Current Assets ($)
When a Restrictive Policy is
Appropriate?
$
Minimum
point
Total costs of holding current assets
Carrying costs
Shortage
costs
CA*
Investment in
Current Assets ($)
Alternative Financing Policies for
Current Assets
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A flexible short-term financing policy means low proportion of
short-term debt relative to long-term financing.
A restrictive short-term financing 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.
Financing Policy for an Idealized Economy
Current assets =
Short-term debt
$
Long-term
debt plus
common
stock
Fixed assets: a
growing firm
0
1
2
3
4
5
Time
Grain elevator operators buy crops after harvest, store them, and sell
them during the year. Inventory is financed with short-term debt. Net
working capital is always zero.
Alternative Asset-Financing Strategies
Total Asset
Requirement
$
Total Asset
Requirement
$
Marketable
Securities
Short Term
Financing
Long Term
Financing
Time
Long Term
Financing
Time
Why Use Short-Term Financing?
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There are at least three reasons for the use of permanent
short-term financing, such as
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There are minimum amounts of accounts payable and of
accruals. It is uneconomical for the firm to reduce shortterm debt below those levels.
As long as the yield curve is upsloping, the expected interest
expense of short-term debt is less than that on long-term
debt, though the use of short-term debt is riskier.
Financing with permanent short-term debt allows the firm
substantial flexibility in its package of permanent financing.
Sources of Short-Term Financing
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Nine common sources of short-term financing are:
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Commercial paper
Bankers’ acceptance
Accounts payable
Accruals
Unsecured credit line borrowings
Unsecured notes and term loan borrowings
Secured borrowings with marketable securities as collateral
Secured borrowings with accounts receivable as collateral
Secured borrowings with inventory as collateral
The first six of these are unsecured borrowings, while the last
three involves secured transactions.
Characteristics of Sources of Short-Term
Financing
Sources
Users
Maturity
Commercial
paper
Large firms and small firms
with bank guarantee
270 days; most
common is 30 days
Bankers’
acceptance
Firms importing goods
30-180 days; most
common 90 days
Accounts payable Any purchaser of goods or
services
30 days most
common
Accruals
Firms who may defer labor,
taxes etc.
Depends on specific
accruals
Unsecured credit
line
Firms with strong financial
position
Can be drawn down
or paid off any time
Unsecured short- Firms with strong financial
term notes
position
Most common 90
days
Characteristics of Sources of Short-Term
Financing
Sources
Secured borrowing
using marketable
securities
Users
Firms holding
marketable securities
Maturity
Typically of very short
maturities
Secured borrowings Firms with liquid and
using accounts
substantial accounts
receivable
receivable
Loans are due when
invoices are paid
Secured borrowings Firms with liquid and
using inventory
substantial inventory
Loans are made when
inventory is acquired
and are due when
inventory is used
Cash Budgeting
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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
Cash Budgeting
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The cash balance tells the manager what borrowing is required
or what lending will be possible in the short run.
The Short-Term Financial Plan
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The most common way to finance a temporary cash deficit to
arrange a short-term loan.
Unsecured Loans
 Line of credit down at the bank
Secured Loans
 Accounts receivable financing can be either assigned or
factored.
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Inventory loans use inventory as collateral.
Other Sources
 Banker’s acceptances
 Commercial paper.
Summary & Conclusions
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This chapter introduces the management of short-term finance.
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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.
Summary & Conclusions
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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 short-term
financial planning is to find the optimal tradeoff between these
two costs.
Summary & Conclusions
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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.
The financial manager can use the cash budget to identify shortterm financial needs.
The cash budget tells the manager what borrowing is required or
what lending will be possible in the short run.