Chapter 18:

Short term Finance and Planning

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 Learning Objectives

The operating and cash cycles and why they are

important

The different types of short-term financial policy

The essentials of short term financial planning

The sources and uses of cash on the balance sheet

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Sources and Uses of Cash
• Balance sheet identity (rearranged)
 NWC + fixed assets = long-term debt + equity
 NWC = cash + other CA – CL
 Cash = long-term debt + equity + CL – CA other than cash – fixed
assets

• Sources
 Increasing long-term debt, equity, or current liabilities
 Decreasing current assets other than cash, or fixed assets

• Uses
 Decreasing long-term debt, equity, or current liabilities
 Increasing current assets other than cash, or fixed assets 3
The Operating Cycle

• Operating cycle – time between purchasing the inventory

and collecting the cash from sale of the inventory

• Inventory period – time required to purchase and sell the

inventory

• Accounts receivable period – time required to collect on

credit sales

• Operating cycle = inventory period + accounts receivable

period
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Cash Cycle

• Cash cycle
 Amount of time we finance our inventory
 Difference between when we receive cash from the sale and
when we have to pay for the inventory

• Accounts payable period – time between purchase of

inventory and payment for the inventory

• Cash cycle = Operating cycle – Accounts payable period

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Figure 18.1: Cash Flow Time Line of a Typical
Manufacturing Firm

18-6
 Example Information
• Inventory:
 Beginning = 300,000
 Ending = 400,000
• Accounts Receivable:
 Beginning = 150,000
 Ending = 200,000
• Accounts Payable:
 Beginning = 50,000
 Ending = 100,000
• Net sales = 1,000,000
• Cost of Goods sold = 700,000

18-7
 Example: Operating Cycle
• Inventory period
 Average inventory = (300,000+400,000)/2 = 350,000
 Inventory turnover = 700,000 / 350,000 = 2 times
 Inventory period = 365 / 2 = 183 days

• Receivables period
 Average receivables = (150,000+200,000)/2 = 175,000
 Receivables turnover = 1,000,000 / 175,000 = 5.71 times
 Receivables period = 365 / 5.71 = 64 days

• Operating cycle = 183 + 64 = 247 days

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 Example: Cash Cycle
• Payables Period
 Average payables = (50,000+100,000)/2 = 75,000
 Payables turnover = 800,000 / 75,000 = 10.67 times
 Payables period = 365 / 10.67 = 34.21 days

• Cash Cycle = 247 – 34 = 213 days

• We have to finance our inventory for 213 days

• If we want to reduce our financing needs, we need to look

carefully at our receivables and inventory periods – they both
seem extensive. A comparison to industry averages would help
solidify this assertion. 18-9
 Short-Term Financial Policy
• Size of investments in current assets
 Flexible (conservative) policy – maintain a high ratio of
current assets to sales
 Restrictive (aggressive) policy – maintain a low ratio of
current assets to sales

• Financing of current assets

 Flexible (conservative) policy – less short-term debt
and more long-term debt
 Restrictive (aggressive) policy – more short-term debt
and less long-term debt
18-10
Carrying vs. Shortage Costs

• Managing short-term assets involves a trade-off between

carrying costs and shortage costs
 Carrying costs – increase with increased levels of
current assets, the costs to store and finance the
assets
 Shortage costs – increase with decreased levels of
current assets
• Trading or order costs
• Costs related to safety reserves, i.e., lost sales and
customers, and production stoppages
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Temporary vs. Permanent Assets
• Temporary current assets
 Sales or required inventory build-up may be seasonal
 Additional current assets are needed during the
“peak” time
 The level of current assets will decrease as sales
occur

• Permanent current assets

 Firms generally need to carry a minimum level of
current assets at all times
 These assets are considered “permanent” because the
level is constant, not because the assets aren’t sold 12
 Figure 18.4
Total Asset Requirement Over Time

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 Choosing the Best Policy
• Cash reserves
 High cash reserves mean that firms can avoid financial distress and better
able to handle emergencies or take advantage of unexpected
opportunities
 Cash and marketable securities earn a lower return and are zero NPV
investments

• Maturity hedging
 Try to match financing maturities with asset maturities
 Finance temporary current assets with short-term debt
 Finance permanent current and fixed assets with long-term debt and
equity

• Interest Rates
 Short-term rates are normally lower than long-term rates, so it may be
cheaper
 Firms can get into trouble if rates increase quickly or if it begins to have
difficulty making payments – may not be able to refinance the short-term
loans 14
 Figure 18.6
A Compromise Financing Policy

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 Cash Budget

• Forecast of cash inflows and outflows over the next short-

term planning period

• Primary tool in short-term financial planning

• Helps determine when the firm will experience cash

surpluses and when it will need to borrow to cover working-
capital requirements

• Allows a company to plan ahead and begin the search for

financing before the money is actually needed
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Example: Cash Budget information

• Growing Tree Corporation sells educational toys for children.

• Sales Forecast
• Q1=48,000; Q2=$60,000; Q3=$66,000; Q4=$81,000; Q5=$57,000
• Accounts receivable
• Beginning receivables = $25,000
• Average collection period = 30 days
• Accounts payable
• Purchases= 50% of next quarter’s sales
• Beginning payables = $12,000
• Average collection period = 45 days
• Other expenses
 Wages, taxes, and other expense are 25% of sales
 Interest and dividend payments are $9,000
 A major capital expenditure of $30,000 is expected in the second quarter
• The initial cash balance is $10,000, and the company maintains a minimum balance
of $5,000
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 EXAMPLE: CASH BUDGET – CASH COLLECTIONS
• 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 $25,000 will be collected in the first quarter

Q1 Q2 Q3 Q4 Q5
Beginning 25,000 16,000 20,000 22,000 27,000
Receivables
Sales 48,000 60,000 66,000 81,000 57,000
Cash Collections 57,000 56,000 64,000 76,000 65,000
Ending 16,000 20,000 22,000 27,000 19,000
Receivables
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 EXAMPLE: CASH BUDGET – CASH DISBURSEMENTS

• 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 = $12,000
Q1 Q2 Q3 Q4
Payment of accounts 27,000 31,500 36,750 34,500
Wages, taxes and 12,000 15,000 16,500 34,500
other expenses
Capital expenditures 30,000
Interest and dividend payments 9,000 9,000 9,000 9,000
Total cash disbursements 48,000 85,500 62,250 63,750

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EXAMPLE: CASH BUDGET – NET CASH FLOW AND CASH BALANCE

Q1 Q2 Q3 Q4
Total cash collections 57,000 56,000 64,000 76,000

Total cash disbursements 48,000 85,500 62,250 63,750

Net cash inflow 9,000 -29,500 1,750 12,250

Beginning Cash Balance 10,000 19,000 -10,500 -8,750

Net cash inflow 9,000 -29,500 1,750 12,250

Ending cash balance 19,000 -10,500 -8,750 3,500

Minimum cash balance -5,000 -5,000 -5,000 -5,000

Cumulative surplus (deficit) 14,000 -15,500 -13,750 -1,500

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Short-Term Borrowing
• Unsecured Loans
 Line of credit
 Committed vs. noncommitted
 Revolving credit arrangement
 Letter of credit
• Secured Loans
 Accounts receivable financing
• Assigning
• Factoring
 Purchase order (PO) financing
 A popular form of factoring used by small/midsized companies
 Inventory loans
• Blanket inventory lien
• Trust receipt
• Field warehouse financing
• Commercial Paper
• Trade Credit
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Example: Compensating Balance

• We have a $500,000 line of credit with a 15% compensating balance

requirement. The quoted interest rate is 9%. We need to borrow
$150,000 for inventory for one year.

• How much do we need to borrow?

• 150,000 / (1 – 0.15) = 176,471

• What interest rate are we effectively paying?

• Interest paid = 176,471 (.09) = 15,882
• Effective rate = 15,882 / 150,000 = 0.1059 or 10.59%
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Example: Factoring

• Last year your company had average accounts receivable of $2

million. Credit sales were $24 million. You factor receivables
by discounting them at 2%. What is the effective rate of
interest?

• Receivables turnover = 24 / 2 = 12 times

• APR = 12(.02/.98) = 0.2449 or 24.49%
• EAR = (1+.02/.98)12 – 1 = 0.2743 or 27.43%

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Short-Term Financial Plan

• To illustrate a completed short term financial plan, we will

assume that Growing Tree arranges to borrow any needed
funds on a short term basis. The interest rate is 20% APR and
its calculated on a quarterly basis, the rate is 20%/4= 5%.
• Lets calculate the Growing Tree short term financial plan.

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Short-Term Financial Plan
Q1 Q2 Q3 Q4

Beginning cash balance 10,000 19,000 5,000 5,000

Net cash inflow 9,000 (29,500) 1,750 12,250

New short-term borrowing 15,500

Interest on short-term investment (loan) (775) (726,25)

Short-term borrowing repaid (975) (11,523.75)

Ending cash balance 19,000 5,000 5,000 5,000

Minimum cash balance (5,000) (5,000) (5,000) (5,000)

Cumulative surplus (deficit) 14,000 0 0 0

Beginning short-term debt 0 0 15,500 14,525

Change in short-term debt 0 5,000 (975) (11,523.75)

Ending short-term debt 0 5,0000 14,525 3,001.25

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