Lecture – 4: Short-Term Finance

and Planning
Project Financial Management
 Short-term finance
• Short-term finance is primarily concerned with the
analysis of decisions that affect current assets and current
liabilities.

• The term net working capital is associated with short-term

financial decision making. net working capital is the
difference between current assets and current liabilities.
Often, short-term financial management is called working
capital management .

• The most important difference between short-term and

long-term finance is in the timing of cash flows.
 Typical Issues covered in Short term finance
• What is a reasonable level of cash to keep on hand (in a
bank) to pay bills?

• How much should the firm borrow in the short term?

• How much credit should be extended to customers?

 Three Basic Elements of Short Term Finance
• The short-term operating activities of the firm

• Alternative short-term financial policies

• Basic elements in a short-term financial plan

 Cash and Net Working Capital
• Recall that current assets are cash and other assets that are
expected to convert to cash within the year. Current assets
are presented on the balance sheet in order of their
accounting liquidity. e.g, cash and cash equivalents,
marketable securities, accounts receivable, and
inventories.
• Current liabilities are obligations that are expected to
require cash payment within one year
• Three major items found as current liabilities are accounts
payable, expenses payable (including accrued wages and
taxes), and notes payable.
Cash and Net Working Capital
 Activities That Increase Cash
• Increasing long-term debt (borrowing over the long term)

• Increasing equity (selling some stock)

• Increasing current liabilities (getting a 90-day loan)

• Decreasing current assets other than cash (selling some

inventory for cash)

• Decreasing fixed assets (selling some property)

 Activities That Decrease Cash
• Decreasing long-term debt (paying off a long-term debt)

• Decreasing equity (repurchasing some stock)

• Decreasing current liabilities (paying off a 90-day loan)

• Increasing current assets other than cash (buying some

inventory for cash)

• Increasing fixed assets (buying some property)

• Activities that increase cash are called sources of cash .
Those activities that decrease cash are called uses of
cash . Looking back at our list, we see that sources of
cash always involve increasing a liability (or equity)
account or decreasing an asset account. This makes sense
because increasing a liability means that we have raised
money by borrowing it or by selling an ownership interest
in the firm. A decrease in an asset means that we have
sold or otherwise liquidated an asset. In either case thereis
a cash inflow.
 The Operating Cycle and the Cash Cycle
• The primary concern in short-term finance is the firm’s
short-run operating and financing activities. For a typical
manufacturing firm, these short-run activities might
consist of the following sequence of events and decisions:
 The Operating Cycle and the Cash Cycle
• We can start with a simple case. One day, call it Day 0, we
purchase $1,000 worth of inventory on credit. We pay the
bill 30 days later, and, after 30 more days, someone buys
the $1,000 in inventory for $1,400. Our buyer does not
actually pay for another 45 days. We can summarize these
events chronologically as follows:
 The Operating Cycle and the Cash Cycle
• The entire cycle, from the time we acquire some
inventory to the time we collect the cash, takes 105 days.
This is called the operating cycle.

• This cycle has two distinct components. The first part is

the time it takes to acquire and sell the inventory. This
period, a 60-day span in our example, is called the
inventory period.
• The second part is the time it takes to collect on the sale,
45 days in our example. This is called the accounts
receivable period.
 The Operating Cycle and the Cash Cycle
• What the operating cycle describes is how a product
moves through the current asset accounts. The product
begins life as inventory, it is converted to a receivable
when it is sold, and it is finally converted to cash when
we collect from the sale. Notice that, at each step, the
asset is moving closer to cash.
 The Operating Cycle and the Cash Cycle
• cash flows and other events that occur are not
synchronized. For example, we don’t actually pay for the
inventory until 30 days after we acquire it. The intervening
30-day period is called the accounts payable period. Next,
we spend cash on Day 30, but we don’t collect until Day
105. Somehow, we have to arrange to finance the $1,000 for
105 -30 =75 days. This period is called the cash cycle.
• The cash cycle, therefore, is the number of days that pass
before we collect the cash from a sale, measured from
when we actually pay for the inventory
 The Operating Cycle and the Cash Cycle
• Based on our definitions, the cash cycle is the difference
between the operating cycle and the accounts payable
period:
The Operating Cycle and the Cash Cycle
 The Operating Cycle and the Cash Cycle
• The gap between short-term inflows and outflows can be
filled either by borrowing or by holding a liquidity
reserve in the form of cash or marketable securities.
Alternatively, the gap can be shortened by changing the
inventory, receivable, and payable periods. These are all
managerial options that we will discuss.

• Amazon.com and Boeing Company.

CALCULATING THE OPERATING AND CASH CYCLES
 CALCULATING THE OPERATING AND CASH CYCLES
• First of all, we need the inventory period. We spent
• $8.2 million on inventory (our cost of goods sold). Our
average inventory was $2.5 million. We thus turned our
inventory over $8.2/2.5 times during the year:

• this tells us that we bought and sold off our inventory

3.28 times during the year.
 CALCULATING THE OPERATING AND CASH CYCLES

• the inventory period is about 111 days. On average, in

other words, inventory sat for about 111 days before it
was sold

• we turn over our receivables 6.4 times a year

 CALCULATING THE OPERATING AND CASH CYCLES

• The receivables period is also called the days ’ sales in

receivables, or the average collection period . Whatever it
is called, it tells us that our customers took an average of
57 days to pay.
 CALCULATING THE OPERATING AND CASH CYCLES
• The operating cycle is the sum of the inventory and
receivables periods:

• This tells us that, on average, 168 days elapse between the

time we acquire inventory and, having sold it, collect for
the sale.
 CALCULATING THE OPERATING AND CASH CYCLES

• So, on average, there is a 129-day delay between the time

we pay for merchandise and the time we collect on the
sale.
 INTERPRETING THE CASH CYCLE
• Our examples show that the cash cycle depends on the
inventory, receivables, and payables periods. The cash
cycle increases as the inventory and receivables periods
get longer. It decreases if the company is able to defer
payment of payables and thereby lengthen the payables
period.
• A lengthening cycle can indicate that the firm is having
trouble moving inventory or collecting on its receivables.
Such problems can be masked, at least partially, by an
increased payables cycle, so both cycles should be
monitored.
 OPERATING AND CASH CYCLES
• In 2011, CFO magazine published its survey of working
capital for various industries. The results of this survey
highlight the marked differences in cash and operating
cycles across industries.
 Aspects of Short-Term Financial Policy
• The policy that a firm adopts for short-term finance will be
composed of at least two elements:

• The size of the firm’s investment in current assets : This is usually

measured relative to the firm’s level of total operating revenues. A
flexible or accommodative short-term financial policy would
maintain a high ratio of current assets to sales. A restrictive short-
term financial policy would entail a low ratio of current assets to
sales.

• The financing of current assets : This is measured as the proportion

of short-term debt to long-term debt. A restrictive short-term
financial policy means a high proportion of short-term debt relative
to long-term financing, and a flexible policy means less short-term
debt and more long-term debt.
 THE SIZE OF THE FIRM’S INVESTMENT IN CURRENT ASSETS

• Flexible short-term financial policies include:

– Keeping large balances of cash and marketable
securities.
– Making large investments in inventory.
– Granting liberal credit terms, which results in a high
level of accounts receivable.
• Restrictive short-term financial policies are:
– Keeping low cash balances and no investment in
marketable securities.
– Making small investments in inventory.
– Allowing no credit sales and no accounts receivable.
 Carrying and Shortage Costs
• Managing current assets can be thought of as involving a
trade-off between costs that rise with the level of
investment and costs that fall with the level of investment.
Costs that rise with the level of investment in current
assets are called carrying costs. Costs that fall with
increases in the level of investment in current assets are
called shortage costs.