LOS 10 Management of Short-Term Liabilities Learning Outcome Statement (LOS) understand why we need to use short-term financing why use short-term financing identify the sources of short-term financing understand cash budgeting summary and conclusion

Introduction Accounts payable is the Cinderella of the working capital world. While her more glamorous sister functions demand the bulk of a company’s time and attention, accounts payable often lacks the care and attention it deserves. That’s a pity - because this Cinderella can account for about 60 percent of a company’s turnover. And when she is dressed up to go to the ball, the results are immediate and can be simply stunning.

Introduction A payable balance is the result of a company’s need or desire to buy a service, a product, or a commodity. Purchases can be divided into direct purchases (goods and raw materials) or indirect purchases (pens, stationery, and building maintenance and infrastructure costs, for example).

A/P Management – Why Need the Attention? Even a small improvement to the accounts payable element of working capital and the cost of purchases can deliver quick results to the bottom line, often well out of proportion to the amounts involved. These improvements can be broadly equivalent to a significant boost in a company’s sales. For a company facing the reality of static or declining sales, this can spell the difference between collapse and survival, by buying the time needed for rethinking and restructuring. For a company managing growth, the return will be even healthier key figures than would otherwise be the case.

A/P Management – Why Need the Attention? As a broad rule of thumb, we would expect the cost of direct purchases to fall by 3 to 5 percent, meaning that for every $1 billion of purchases, $30–$50 million would feed straight through to the bottom line. A company with a gross margin of 15 percent would need to increase sales by $500 million to generate that much extra net cash. An increase in creditor days by 15 to 30 percent is also often achieved, giving a further boost to working capital.

Objectives of Current Liabilities The structure of a firm’s current liabilities should achieve two goals, such as It should provide the necessary amounts of short-term financing It should be in keeping with the target level of aggregate liquidity. The challenge in the management of current liabilities is to achieve these goals at a minimum cost.

The Balance-Sheet Model of the Firm Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt What long-term investments should the firm engage in? The Capital Budgeting Decision

The Balance-Sheet Model of the Firm How can the firm raise the money for the required investments? The Capital Structure Decision Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt

The Balance-Sheet Model of the Firm How much short- term cash flow does a company need to pay its bills? The Net Working Capital Investment Decision Net Working Capital Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt

Types of Short-Term Financing Short-term financing is a liability that originally scheduled for repayment within one year. Short-term financing can be classified as temporary short- term financing and permanent short-term financing. Temporary short-term financing is used to provide funds for transient cash flow shortages, such as those caused by seasonality in sales. When it is cheaper to borrow funds to cover such deficits than to keep a reserve of funds against them, temporary borrowings are attractive to the firm. Permanent short-term financing are used by firms on a continuing basis and are refinanced with new short-term debt as they mature.

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

The Size of the 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).

Carrying Costs and Shortage Costs $ Investment in Current Assets ($) Shortage costs Carrying costs Total costs of holding current assets CA * Minimum point

Appropriate Flexible Policy $ Investment in Current Assets ($) Shortage costs Carrying costs Total costs of holding current assets CA * Minimum point

When a Restrictive Policy is Appropriate? $ Investment in Current Assets ($) Shortage costs Carrying costs Total costs of holding current assets CA * Minimum point

Alternative Financing Policies for Current Assets A flexible short-term financing policy means low proportion of short-term debt relative to long-term financing. A restrictive short-term financing policy means 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 always zero.

Financing Policy for an Idealized Economy Long-term debt plus common stock $ Time Current assets = Short-term debt Fixed assets: a growing firm Grain elevator operators buy crops after harvest, store them, and sell them during the year. Inventory is financed with short-term debt. Net working capital is always zero.

Alternative Asset-Financing Strategies $ Time Long Term Financing Short Term Financing Total Asset Requirement $ Time Long Term Financing Marketable Securities Total Asset Requirement

Why Use Short-Term Financing? There are at least three reasons for the use of permanent short-term financing, such as There are minimum amounts of accounts payable and of accruals. It is uneconomical for the firm to reduce short- term debt below those levels. As long as the yield curve is upsloping, the expected interest expense of short-term debt is less than that on long-term debt, though the use of short-term debt is riskier. Financing with permanent short-term debt allows the firm substantial flexibility in its package of permanent financing.

Sources of Short-Term Financing Nine common sources of short-term financing are: Commercial paper Bankers’ acceptance Accounts payable Accruals Unsecured credit line borrowings Unsecured notes and term loan borrowings Secured borrowings with marketable securities as collateral Secured borrowings with accounts receivable as collateral Secured borrowings with inventory as collateral The first six of these are unsecured borrowings, while the last three involves secured transactions.

Characteristics of Sources of Short-Term Financing SourcesUsersMaturity Commercial paper Large firms and small firms with bank guarantee 270 days; most common is 30 days Bankers’ acceptance Firms importing goods days; most common 90 days Accounts payableAny purchaser of goods or services 30 days most common AccrualsFirms who may defer labor, taxes etc. Depends on specific accruals Unsecured credit line Firms with strong financial position Can be drawn down or paid off any time Unsecured short- term notes Firms with strong financial position Most common 90 days

Characteristics of Sources of Short-Term Financing SourcesUsersMaturity Secured borrowing using marketable securities Firms holding marketable securities Typically of very short maturities Secured borrowings using accounts receivable Firms with liquid and substantial accounts receivable Loans are due when invoices are paid Secured borrowings using inventory Firms with liquid and substantial inventory Loans are made when inventory is acquired and are due when inventory is used

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

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

The Short-Term Financial Plan The most common way to finance a temporary cash deficit to arrange a short-term loan. Unsecured Loans Line of credit down at the bank Secured Loans Accounts receivable financing can be either assigned or factored. Inventory loans use inventory as collateral. Other Sources Banker’s acceptances Commercial paper.

Summary & Conclusions This chapter introduces the management of short-term finance. We examine the short-term uses and sources of cash as they appear on the firm’s financial statements. We see how current assets and current liabilities arise in the short-term operating activities and the cash cycle of the firm. From an accounting perspective, short-term finance involves net working capital.

Summary & Conclusions Managing short-term cash flows involves the minimization of costs. The two major costs are: Carrying costs - the interest and related costs incurred by overinvesting in short-term assets such as cash Shortage costs - the cost of running out of short-term assets. The objective of managing short-term finance and short-term financial planning is to find the optimal tradeoff between these two costs.

Summary & Conclusions In an ideal economy, the firm could perfectly predict its short-term uses and sources of cash and net working capital could be kept at zero. In the real world, net working capital provides a buffer that lets the firm meet its ongoing obligations. The financial manager seeks the optimal level of each of the current assets. The financial manager can use the cash budget to identify short- term financial needs. The cash budget tells the manager what borrowing is required or what lending will be possible in the short run.