CHAPTER 20 Short -Term Financial Planning and Budgeting Working capital Cash conversion cycle Working capital policies Short-term financing Cash budget

Definitions: Gross W.C.: Total current assets. Net W.C.: CA - CL W.C. Policy: Decisions as to: the level of each type of current asset how current assets will be financed W.C. Management: controlling cash, inventory, accounts receivable, and short term liabilities.

1995 Balance Sheet ASSETS LIABILITIES Cash $ 100 A/P& Acc. $ 300 Acct. Rec. 600 Notes 8% 500 Inventory 1,000 LT Debt 12% 600 Fixed Assets 800 Com. Eq. 1,100 Total Assets $2,500 Tot. Claims $2,500 Net Working Capital = $1,700 - $800 = $900.

1995 Income Statement $5,000.00 Sales 3,700.00 Variable Costs 1,000.00 Fixed Costs EBIT Interest EBT Taxes(40%) Net Income Dividends (30%) Add. to RE $5,000.00 3,700.00 1,000.00 $ 300.00 112.00 188.00 75.20 $ 112.80 $ 33.84 $ 78.96

Key Ratios This company is in poor shape. Why? NYF Industry BEP 12.0% 15.8% Poor PM 2.3% 3.0% “ ROE 10.3% 15.0% “ DSO 43.2 days 30 days “ Rec. T.O. 8.3x 12.0x “ Inv. T.O. 5.0x 7.5x “ F.A.T.O. 6.3x 6.0x OK T.A.T.O. 2.0x 2.5x Poor D/A 56% 50% Poor TIE 2.7% 4.8% “ Current ratio 2.1x 2.3x “ Quick ratio 0.9x 1.3x “ This company is in poor shape. Why?

How does NYF’s working capital policy compare with an average firm in the industry? Working capital policy is reflected in DSO, receivables turnover, and inventory turnover. These ratios indicate that NYF is not managing its working capital efficiently. This will affect profitability and price.

Calculate the inventory conversion period. Conversion = Inventory = $1,000 Period Sales/day $5,000 360 = 72 days vs. 48 days ind. avg.

Calculate the collection period. Receivables collection = DSO = A/R period Sales/day = $600 $5,000/360 = 43.2 days versus ind avg. 30 days

If payables can be deferred for the industry average of 29 days, what is the cash conversion cycle? Deferral Period Inventory Conversion Period Receivables Conversion Period CCC = + - = 72 + 43.2 - 29 = 86.2 days Avg. = 48 + 30 + 29 = 49 days

How could the CCC concept help improve working capital management? Presently, the firm must finance its current assets for 86.2 days. If it could sell inventory faster, collect receivables faster, or take longer to pay suppliers, it could reduce current asset financing costs. If these actions didn’t lower sales or increase operating costs, profitability would improve.

Alternative Working Capital Policies W.C. Policy Fixed Costs* Restrictive $ 950,000 Moderate 1,000,000 Relaxed 1,100,000 * Insurance, warehouse costs, etc. Sales (millions of dollars) Economy Restrictive Moderate Relaxed Weak $4.3 $4.5 $5.0 Average 4.7 5.0 5.5 Strong 5.3 5.5 6.0

Recast the 1995 income statement and ratios assuming: Restrictive policy, average economy Sales = $4,700,000 Variable Costs = .74 (Sales) Fixed Costs = $1,000 (mod) 950 (restrictive) 1,100 (relaxed)

1995, Restricitive Working Capital Policy 1995: Orig. 1995 Recast Sales Fixed Costs Var. Costs EBIT Interest EBT Taxes(40%) Net Income Dividends Add. to RE $5,000.00 3,700.00 1,000.00 $ 300.00 112.00 188.00 75.20 $ 112.80 $ 33.80 $ 79.00 $4,700.00 3,478.00 950.00 $272.00 112.00 160.00 64.00 96.00 $ 28.80 $ 67.20 Sales and profits decline, but fewer shares are outstanding, so EPS and ROE should rise.

Revised 1995 balance sheet: Restrictive working capital, Average economy: Cash/Sec. $ 100 A/P & Accr. $ 300 A/R 500 N/P (8%) 500 Inventory 800 Total CL $ 800 Total CA $ 1,400 LT Debt (12%) 600 Net fixed Common eq. 800 assets 800 ______ Total assets $ 2,200 Total Claims $ 2,200 Current assets are lower: debt and F.A. are held constant; common equity is lowered. T.A. are lower by $300.

Effects of restrictive W.C. Policy: Current ratio = $1,400/$800 = 1.75 (somewhat riskier than before). Return on equity = $96/$800 = 12.0%, up from 10.3%, so higher profitability. EPS would rise, but we don’t know shares so we can’t calculate it.

ROE Under Alternative Policies Economy Weak Average Strong E(ROE) Restr. 4.2% 12.0% 23.7% 13.3% Mod 3.2% 10.3% 17.3% Relaxed 3.8% 9.3% 14.9% The restrictive policy dominates--best under all economic conditions. Not always true.

What are the implications of these data for the working capital policy decision? Restrictive: ROE is leveraged and im- pacted by changes in sales. Produces highest ROE for each state of the economy, highest average ROE, but the greatest variability of ROEs. Relaxed: Produces lowest average ROE and the smallest variability. Moderate: Results in ROE and variability between the other 2 policies.

Working Capital Financing Policies Moderate: Use securities whose maturity matches that of the assets being financed. Aggressive: Use short-term debt to finance permanent assets. Conservative: Use long-term capital for both permanent and temporary assets.

Moderate (Matching) Financing Policy $ S-T Loans Temp. C.A. Total Perm. Assets Permanent Current Assets L-T Capital Fixed Assets Years

Aggressive Financing Policy $ Temp. C.A. S-T Loans Permanent Current Assets L-T Fin: Stock Bonds Spon. C.L. Fixed Assets Years Lower dashed line to become more aggressive.

Conservative Financing Policy $ Marketable Securities Permanent Current Assets L-T Capital Fixed Assets Years Use zero S-T debt.

Is S-T debt riskier than L-T debt? To company, yes. Short-term interest rates may rise, which would lower profits. Also, may have trouble rolling over loans. Advantages of S-T credit: Low cost with normal yield curve. Can get funds relatively quickly, and then repay without penalty if funds no longer needed.

Cash budget: The primary cash management tool Purpose: Used to forecast cash flows, hence borrowing requirements or surplus cash to invest. Timing: Daily, weekly, monthly, depending on purpose of forecast. Monthly for annual planning, daily for actual cash management.

Data required for the Cash Budget Sales forecast. Forecast of collection delays. Forecast of purchases and of payment terms. Forecast of cash expenses. Initial cash balance. Target cash balance.

Data used in Cash Budget: Sales: Nov $ 500 April $ 5,800 Dec 500 May 3,300 Jan 200 June 1,000 Feb 200 July 800 Mar 3,200 August 1,000 Collections: Sell 2/10 net 30. 40% take discount, pay in 10 days. 50% pay in 30 days. 10% pay in 60 days. (More...)

Purchases: 75% of sales, 2 months in advance Purchases: 75% of sales, 2 months in advance. Pay 30 days after purchases. Depreciation: $42,500 per month. Cash expenses (wages, selling, etc.): $140,000 per month. Income taxes: $125,000 in March & June. Other expenses: $250,000 in April for advertising program. Initial cash: $300,000 on January 1. Target cash balance: $200,000.

Sales/Collections: Nov Dec Jan Feb * (Sales)(% collected)(1-discount) 1st mos. (40%) 78.4* 78.4* 2nd mos (50%) 250.0 100.0 3rd mos. (10%) 50.0 50.0 Cash collected 378.4 228.4 * (Sales)(% collected)(1-discount) = ($200) ( 0.4) (0.98) = $78.4

Purchases/Payments Nov Dec Jan Feb Mar Sales 500 500 200 200 3,200 Purchases: *150 150 2,400 Cash Pmts: 150 150 2,400 *Purchases = 0.75 (sales expected 2 months forward)

Net Cash Inflow/outflow Collections Purchases Other Expenses Taxes Advertising Net Cash Flow Jan $378 -150 -140 88 Feb Mar Apr $ 346 1,374 3,894 -2,400 -4,350 -2,475 - 140 - 140 - 140 0 -125 0 0 0 -250 -2,312 -3,241 1,029

Cash Surplus or Loan Jan Feb Mar Apr Net Cash Flow $88 -2,312 -3,241 1,029 Cash at Start 300 388 -1,923 -5,154 Cumulative 388 1,923 -5,164 -4,135 Target cash -200 -200 - 200 -200 Surplus (loan) $188 -2,123 -5,364* -4,335 * Peak need: $5,364 in March. If extended, would see $1,045 surplus at end of June.

Uses of the Cash Budget Arrange line of credit. Shows maximum expected shortfall of $5,364,000 during March. Can then arrange line of credit with bank ahead of need. Might ask for $6 million line, but may have to pay a “commitment fee”. Plan to invest surpluses. Think about how to invest surplus funds.

Should depreciation be explicitly included in the cash budget? No. Depreciation is a noncash charge. Only cash payments and receipts appear on cash budget. However, depreciation does affect taxes, which do appear in the cash budget.

What would happen if all outflows occur on the 5th day of each month but inflows occur on the 25th? Monthly budget would underestimate the borrowing requirements on 5th day. 100% of outflows occur by then but no inflows- only cash on hand would be available. Firm would need an additional $4,415,000, so a credit line of at least $4,415,000 + $1,923,000 = $6,338,000 would be needed. Need a daily cash budget, larger credit line, if inflows/ouflows aren’t synchronized.

What are some other potential cash inflows besides collections? Proceeds from the sale of fixed assets. Proceeds from stock and bond sales. Interest earned. Court settlements received.

How can interest earned or paid be incorporated into the cash budget? Interest earned: Add row in the collections section. Interest paid: Add row in the payments section. Found as interest rate x surplus/loan shown on cash budget for preceding month. In theory, “feedback” loops needed because interest income/expense would affect surplus/deficit.

How could bad debts be worked into the cash budget? Collections would be reduced by the amount of the bad debt losses. For example, if the firm had 3% bad debt losses, collections would total only 97% of sales. Lower collections would lead to higher borrowing requirements.

How can uncertainty be incorporated into the cash budget? Our cash budget uses expected values for all inputs. Sensitivity and scenario analyses could be applied. Play “what if.” What if sales decline, collections slow down, etc. Then how much credit needed?

Higher sales would eventually lead to higher surpluses, but initially borrowing requirements would be higher because of lags. Lower sales would probably lead to lower eventual surpluses, but to lower borrowing requirements. Impact of sales variability depends on how quickly the firm reacts to departures from sales forecasts.