Finance Discussion Topic #4

McGraw-Hill/Irwin

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Short-Term Finance and Planning

Chapter 26

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Key Concepts and Skills

• Understand the components of the cash cycle and why it is important
• Understand the pros and cons of the various short-term financing policies
• Be able to prepare a cash budget
• Understand the various options for short-term financing

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Chapter Outline

26.1 Tracing Cash and Net Working Capital

26.2 The Operating Cycle and the Cash Cycle

26.3 Some Aspects of Short-Term Financial Policy

26.4 Cash Budgeting

26.5 The Short-Term Financial Plan

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Balance Sheet Model of the Firm

How much short-term cash flow does a company need to pay its bills?

Net Working Capital

Current Assets

Fixed Assets

1. Tangible

2. Intangible

Shareholders’ Equity

Current Liabilities

Long-Term Debt

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26.1 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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Defining Cash in Terms of Other Elements

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Defining Cash in Terms of Other Elements

• An increase in long-term debt and or equity leads to an increase in cash—as does a decrease in fixed assets or a decrease in the non-cash components of net working capital.
• The sources and uses of cash follow from this reasoning.

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26.2 The Operating Cycle and the Cash Cycle

Time

Accounts payable period

Operating cycle

Cash received

Finished goods sold

Firm receives invoice

Cash paid for materials

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The Operating Cycle and the Cash Cycle

• 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, respectively.

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Example

• Inventory:
• Beginning = 200,000
• Ending = 300,000
• Accounts Receivable:
• Beginning = 160,000
• Ending = 200,000
• Accounts Payable:
• Beginning = 75,000
• Ending = 100,000
• Net sales = 1,150,000
• Cost of Goods sold = 820,000

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Example

• 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 = 111.3 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 = 57.1 days
• Operating cycle = 111.3 + 57.1 = 168.4 days

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Note: the values could be calculated using strictly ending values, rather than average values, for inventory, receivables, and payables.

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Example

• Payables Period
• Average payables = (75,000+100,000)/2 = 87,500
• Payables turnover = 820,000 / 87,500 = 9.37 times
• Payables period = 365 / 9.37 = 38.9 days
• Cash Cycle = 168.4 – 38.9 = 129.5 days
• We have to finance our inventory for 129.5 days.
• If we want to reduce our financing needs, we need to look carefully at our receivables and inventory periods – they both seem excessive.

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26.3 Some Aspects of Short-Term Financial Policy

• There are two elements of the policy that a firm adopts for short-term finance.
• 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

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Size of Investment in Current Assets

• 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)

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Carrying Costs and Shortage Costs

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Investment in Current Assets ($)

Carrying costs

Total costs of holding current assets.

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Appropriate Flexible Policy

$

Investment in Current Assets ($)

Carrying costs

Total costs of holding current assets.

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Appropriate Restrictive Policy

$

Investment in Current Assets ($)

Carrying costs

Total costs of holding current assets.

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Alternative Financing Policies

• A flexible short-term finance policy means a low proportion of short-term debt relative to long-term financing.
• A restrictive short-term finance policy means a 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 zero.

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26.4 Cash Budgeting

• 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

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The cash balance tells the manager what borrowing is required or what lending will be possible in the short run.

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Example

• Pet Treats Inc. specializes in gourmet pet treats and receives all income from sales
• Sales estimates (in millions)
• Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550
• Accounts receivable
• Beginning receivables = $250
• Average collection period = 30 days
• Accounts payable
• Purchases = 50% of next quarter’s sales
• Beginning payables = 125
• Accounts payable period is 45 days
• Other expenses
• Wages, taxes and other expense are 30% of sales
• Interest and dividend payments are $50
• A major capital expenditure of $200 is expected in the second quarter
• The initial cash balance is $80 and the company maintains a minimum balance of $50

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Example

• ACP = 30 days, this implies that 2/3 of sales are collected in the quarter made, and the remaining 1/3 are collected the following quarter.
• Beginning receivables of $250 will be collected in the first quarter.

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Example

• Payables period is 45 days, so half of the purchases will be paid for each quarter, and the remaining will be paid the following quarter.
• Beginning payables = $125

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Payment of accounts:

Q1: 125 + .5(600)/2 = 275

Q2: 150 + .5(650)/2 = 313 (rounded to nearest dollar throughout)

Q3: 162 + .5(800)/2 = 362

Q4: 200 + .5(550)/2 = 338

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Example

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The company will need to access a line of credit or borrow short-term to pay for the short-fall in quarter 2, but should be able to clear up the line of credit in quarter 4.

You could also use 50 as the beginning cash balance in quarters following deficits. This would assume funds were borrowed to achieve the target cash balance.

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26.5 The Short-Term Financial Plan

• The most common way to finance a temporary cash deficit is to arrange a short-term loan.
• Unsecured Loans
• Line of credit (at the bank)
• Secured Loans
• Accounts receivable can be either assigned or factored.
• Inventory loans use inventory as collateral.
• Other Sources
• Banker’s acceptance
• Commercial paper

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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?