McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.0 Chapter 16 Short-Term Financial Planning

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.1 Key Concepts and Skills Be able to compute the operating and cash cycles and understand why they are important Understand the different types of short-term financial policy Understand the essentials of short-term financial planning

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.2 Chapter Outline Tracing Cash and Net Working Capital The Operating Cycle and the Cash Cycle Some Aspects of Short-Term Financial Policy The Cash Budget Short-Term Borrowing A Short-Term Financial Plan

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.3 Sources and Uses of Cash Sources of Cash Obtaining financing: Increase in long-term debt Increase in equity Increase in current liabilities Selling assets Decrease in current assets Decrease in fixed assets Uses of Cash Paying creditors or stockholders Decrease in long-term debt Decrease in equity Decrease in current liabilities Buying assets Increase in current assets Increase in fixed assets

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.4 The Operating Cycle The time it takes to receive inventory, sell it and collect on the receivables generated from the sale Operating cycle = inventory period + accounts receivable period Inventory period = time inventory sits on the shelf Accounts receivable period = time it takes to collect on receivables

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.5 The Cash Cycle The time between payment for inventory and receipt from the sale of inventory Cash cycle = operating cycle – accounts payable period Accounts payable period = time between receipt of inventory and payment for it The cash cycle measures how long we need to finance inventory and receivables

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.6 Table 16.1

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.7 Example Information ItemBeginningEndingAverage Inventory200,000300,000250,000 Accounts Receivable 160,000200,000180,000 Accounts Payable 75,000100,00087,500 Net Sales = $1,150,000Cost of Goods Sold = $820,000

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.8 Example - Operating Cycle Inventory Period = 365 / Inventory Turnover Inventory Turnover = COGS / Average inventory IT = 820,000 / 250,000 = 3.28 times Inventory Period = 365 / 3.28 = 111 days Accounts Receivable Period = 365 / Receivables Turnover Receivables Turnover = Credit Sales / Average AR RT = 1,150,000 / 180,000 = 6.4 times Receivables Period = 365 / 6.4 = 57 days Operating cycle = = 168 days

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 16.9 Example - Cash Cycle Accounts Payables Period = 365 / payables turnover Payables turnover = COGS / Average AP PT = 820,000 / 87,500 = 9.4 times Accounts payables period = 365 / 9.4 = 39 days Cash cycle = 168 – 39 = 129 days So, we have to finance our inventory and receivables for 129 days

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Short-Term Financial Policy Flexible (Conservative) Policy Large amounts of cash and marketable securities Large amounts of inventory Liberal credit policies (large accounts receivable) Relatively low levels of short-term liabilities High liquidity Restrictive (Aggressive) Policy Low cash and marketable security balances Low inventory levels Little or no credit sales (low accounts receivable) Relatively high levels of short-term liabilities Low liquidity

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Carrying versus Shortage Costs Carrying costs Opportunity cost of owning current assets versus long-term assets that pay higher returns Cost of storing larger amounts of inventory Shortage costs Order costs – the cost of ordering additional inventory or transferring cash Stock-out costs – the cost of lost sales due to lack of inventory, including lost customers

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Temporary versus Permanent Assets Are current assets temporary or permanent? Both! Permanent current assets refer to the level of current assets that the company retains regardless of any seasonality in sales Temporary current assets refer to the additional current assets that are added when sales are expected to increase on a seasonal basis

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Figure 16.4 Policy F always implies a short-term cash surplus and a large investment in cash and marketable securities. Dollars Policy FPolicy R Long-term financing Total asset requirement Marketable securities Time Long-term financing Time Total asset requirement Short-term financing Policy R uses long-term financing for permanent asset requirements only and short-term borrowing for seasonal variations.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Choosing the Best Policy Best policy will be a combination of flexible and restrictive policies Things to consider Cash reserves Maturity hedging Relative interest rates Compromise policy – borrow short-term to meet peak needs, maintain a cash reserve for emergencies

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Figure 16.5 Dollars Time Flexible policy (F) Compromise policy (C) Restrictive policy (R) Short-term financing Total seasonal variation Marketable securities General growth in fixed assets and permanent current assets With a compromise policy, the firm keeps a reserve of liquidity that it uses to initially finance seasonal variations in current asset needs. Short-term borrowing is used when the reserve is exhausted.

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Cash Budget Primary tool in short-run financial planning Identify short-term needs and potential opportunities Identify when short-term financing may be required How it works Identify sales and cash collections Identify various cash outflows Subtract outflows from inflows and determine investing and financing needs

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Example: Cash Budget Information Expected Sales for 2000 by quarter (millions) Q1: $57; Q2: $66; Q3: $66; Q4: $90 Beginning Accounts Receivable = $30 Average collection period = 30 days Purchases from suppliers = 50% of next quarter’s estimated sales Accounts payable period = 45 days Wages, taxes and other expenses = 25% of sales Interest and dividends = $5 million per quarter Major expansion planned for quarter 2 costing $35 million Beginning cash balance = $5 million with minimum cash balance of $2 million

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Example: Cash Budget – Cash Collections Q1Q2Q3Q4 Beginning Receivables Sales Cash Collections = Beg. Receivables + 2/3(Sales) Ending Receivables = 1/3(Sales)

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Example: Cash Budget – Cash Disbursements Q1Q2Q3Q4 Payment of A/P = 50% of sales Wages, taxes, other expenses Capital Expenditures35.00 Long-term financing (interest and dividends) 5.00 Total Disbursements

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Example: Cash Budget – Net Cash Flow and Cash Balance Q1Q2Q3Q4 Total Cash Collections Total Cash Disbursements Net Cash Flow20.25(26.50) Beginning Cash Balance (1.25)10.25 Net Cash Inflow20.25(26.50) Ending Cash Balance25.25(1.25) Minimum Cash Balance-2.00 Cumulative surplus (deficit)23.25(3.25)

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Short-Term Borrowing Unsecured loans Line of credit – prearranged agreement with a bank that allows the firm to borrow up to a certain amount on a short-term basis Committed – formal legal arrangement that may require a commitment fee and generally has a floating interest rate Non-committed – informal agreement with a bank that is similar to credit card debt for individuals Revolving credit – non-committed agreement with a longer time between evaluations Secured loans – loan secured by receivables or inventory or both

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Example: Factoring Selling receivables to someone else at a discount Example: You have an average of $1 million in receivables and you borrow money by factoring receivables with a discount of 2.5%. The receivables turnover is 12 times per year. What is the APR? Period rate =.025/.975 = 2.564% APR = 12(2.564%) = % What is the effective rate? EAR = – 1 = %

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Short-Term Financial Plan Q1Q2Q3Q4 Beginning Cash Net Cash Inflow20.25(26.50) New Short-Term Debt Interest on Short-Term Debt Short-Term Debt Repayment Ending Cash Balance Minimum Cash Balance-2.00 Cumulative Surplus (Deficit) Beginning Short-Term Debt Change in Short-Term Debt Ending Short-Term Debt

McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved Chapter 16 Quick Quiz Suppose your average inventory is $10,000, your average receivables is $9,000 and your average payables is $4,000. Net sales are $100,000 and cost of goods sold is $50,000. What is the operating cycle and the cash cycle? What are the differences between flexible and restrictive short-term financial policies? What factors do we need to consider when choosing a financial policy? What factors go into determining a cash budget and why is it valuable?