0. Short-term financing & working capital management
RWJ Ch
BMW Ch.30

1. Cash Budgeting
A cash budget is a primary tool of short-run financial planning.
The cash balance tells the manager what borrowing is required or what lending will be possible in the short run.
The idea is simple: Record the estimates of cash receipts and disbursements:
Steps to prepare a cash budget
Forecast the cash receipts
Forecast the cash disbursements
Calculate whether the firm is facing a cash shortage or surplus
The cash balance tells the manager what borrowing is required or what lending will be possible in the short run.

2. Cash Budgeting Cash Receipts: cash inflow (sources of cash)
Arise from sales, but cash comes later from collections on accounts receivables. We need to estimate when we actually collect.
Cash disbursement : cash outflow (uses of cash)
Payments of Accounts Payable
Wages, Taxes, and other Expenses
Capital Expenditures
Long-Term Financial Planning
The cash balance tells the manager what borrowing is required or what lending will be possible in the short run.

3. Example
Pet Treats Inc. specializes in gourmet pet treats and receives all income from sales
Sales estimates (in millions)
Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550
Accounts receivable
Beginning receivables = $250
Average collection period = 30 days
Accounts payable
Purchases = 50% of next quarter’s sales
Beginning payables = $125
Accounts payable period is 45 days
Other expenses
Wages, taxes and other expense are 30% of sales
Interest and dividend payments are $50
A major capital expenditure of $200 is expected in the second quarter
The initial cash balance is $80 and the company maintains a minimum balance of $50

4. Example– cash receipt Sales forecast for the next year by quarter: Q1
500
600
650
800
Cash Receipts: Accounts receivable
Beginning receivables = $250
Average collection period = 30 days
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 $250 will be collected in the first quarter.

5. Example – cash receipt Q1 Q2 Q3 Q4 a. Beginning Receivables 250 167
200
217
b. Sales
500
600
650
800
c. Collections
sales in current period (2/3)
333
400
433
533
sales in last period (1/3)
total cash collections
583
567
633
750
d.Ending Receivables (a+b-c)
267

6. Example –cash disbursement
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 = $125 , last period Q1 Q2 Q3 Q4 Q5
a. Sales
500
600
650
800
550
b. Purchases (1/2 sales)
300
325
400
275
previous period purchase (1/2)
125
150
163
200
138
current period purchase (1/2)
Total payment of accounts
313
362
338
Payment of accounts:
Q1: (600)/2 = 275
Q2: (650)/2 = 313 (rounded to nearest dollar throughout)
Q3: (800)/2 = 362
Q4: (550)/2 = 338

7. Example –cash disbursementQ1 Q2 Q3 Q4
Payment of accounts
275
313
362
338
Wages, taxes and other expenses
150
180
195
240
Capital expenditures
200
Interest and dividend payments 50
Total cash disbursements
475
743
607
628
Payment of accounts:
Q1: (600)/2 = 275
Q2: (650)/2 = 313 (rounded to nearest dollar throughout)
Q3: (800)/2 = 362
Q4: (550)/2 = 338

8. Example Q1 Q2 Q3 Q4 a. Total cash collections 583 567 633 750
b. Total cash disbursements
475
743
607
628
c. Net cash inflow (a-b)
108
-176 26
122
d.Beginning Cash Balance 80
188 12 38
e. Net cash inflow (c.)
f. Ending cash balance (d+e)
160
g. Minimum cash balance
-50
h. Cumulative surplus (deficit) (f+g)
138
-38
-12
110
The company will need to access a line of credit or borrow short-term to pay for the short-fall in quarter 2, but should be able to clear up the line of credit in quarter 4.
You could also use 50 as the beginning cash balance in quarters following deficits. This would assume funds were borrowed to achieve the target cash balance.

9. The Short-Term Financial Plan
There are dozens of ways to finance a temporary cash deficit :
The most common way is to arrange a short-term loan.
Unsecured Loans: Line of credit (at the bank)
Secured Loans: Accounts receivable financing/ inventor loan.
Commercial paper
=> pays interest
Stretching payables
Line of credit – formal or informal prearranged short-term loans
Commitment loan: Commitment fee – charge to secure a committed line of credit
Non commitment loan: Compensating balance – deposit in a low (or no)-interest account as part of a loan agreement
Cost of a compensating balance – if the compensating balance requirement is on the used portion, less money than what is borrowed is actually available for use. If it is on the unused portion, the requirement becomes a commitment fee.
Accounts Receivable Financing
Assigning receivables – receivables are security for a loan, but the borrower retains the risk of uncollected receivables
Factoring – receivables are sold at a discount
Inventory Loans
Blanket inventory lien – all inventory acts as security for the loan
Trust receipt – borrower holds specific inventory in trust for the lender (e.g., automobile dealer financing)
Field warehouse financing – public warehouse acts as a control agent to supervise inventory for the lender
Commercial paper – short-term publicly traded loans, provided by other large companies plenty of cash.
Stretching payables: for the ability of firms to delay their payments in form of the payable accounts. However it is costly.In case of delay, the firm may pay more to their customers.

10. Working capital mamangement
How do firms manage the short-term asset?
Inventory management
Credit management
Cash management
Investing in short-term securities
How can firm finance the short-term asset?
Sources of short-term borrowing

11. Inventory Management Components of Inventory
Raw materials
Work in process
Finished goods
Goal = Minimize amount of cash (cost) tied up in inventory
Tools used to minimize inventory
Just-in-time/Lean manufacturing by Toyota
Customize production through internet by Dell Computer.
Just-in-time and lean manufacturing approach: by Toyota in Japan. Deliver its component hour by hour (zero-inventory).

12. Inventories Trade-off between : Carry cost and order cost.
As the firm increases its order size, the number of orders falls and therefore the order costs decline. However, an increase in order size also increases the average amount in inventory, so that the carrying cost of inventory rises. The trick is to strike a balance between these two costs. 22

13. Inventories Determination of optimal order size Total costs
Carrying costs
Inventory costs, dollars
Total order costs
Order size
Optimal
order size 24

14. Credit management Specify a terms of sales
Design the contract of trade
Estimate the probability of default to pay
Collect your receivables

15. Terms of Sale
Terms of Sale - Credit, discount, and payment terms offered on a sale. Example - 5/10 net percent discount for early payment 10 - number of days that the discount is available net 30 - number of days before payment is due 3

16. Terms of Sale
A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier.
We can calculate the implicit cost of this loan 5

17. Terms of Sale
Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given? 7

18. Credit Analysis
Credit Analysis - Procedure to determine the likelihood a customer will pay its bills.
Credit agencies, such as Dun & Bradstreet provide reports on the credit worthiness of a potential customer.
Financial ratios can be calculated to help determine a customer’s ability to pay its bills. 9

19. The Credit Decision
Extending credit gives you the probability of making a profit, not the guarantee. There is still a chance of default.
Denying credit guarantees neither profit or loss. 17

20. The Credit Decision The credit decision and its probable payoffs
π = prob of default
Rev= Sales’ revenue
Payoff = Rev - Cost
Payoff = - Cost
Customer pays = 1-π
Customer defaults = π
Payoff = 0
Offer credit
Refuse credit 20

21. The Credit Decision
Based on the probability of payoffs, the expected profit can be expressed as:
NPV = (1- π) PV (Rev- Cost)- π PV (Cost)
=- PV (Cost)+ (1- π) PV (Rev)
The break even probability of default (NPV=0) is: p* = 1- [PV (Cost)/ PV(Rev)]
The company should extend the credit as long as the default probability will not exceed the break even point.
The company should extend credit as long as there is a larger than p probability that the customer will pay. 23

22. Example The company is trading with a new customer:
The goods costs $20 in the present period.
If allowing credit sales, the sales’ revenue is $49 to be collected in next period.
The risk free discount rate is 2%.
Should the company grant credit to its customer if the customer has 20% of probability not paying the company ?
NPV = (1-0.2) 49/1.02 =$ 18.43>0 Or
p* = 1- (20/ (49/1.02))= 58.4% >20%

23. Collection Policy
Collection Policy - Procedures to collect and monitor receivables.
Keep track of the collection period through time.
Managing the receivables, e.g. classifying accounts by age.
Be aware and prepared for accounts with high default risk.
Factoring   Arrangement whereby a financial institution buys a company's accounts receivable and collects the debt.
The factor typically charges a fee for administration and for the risk bearing.
In case of nonpayment, the factor pays the client 70%-80% of the value at an agreed interest rate. 24

24. Investing Cash Temporary Cash Surpluses stem from several reasons
Seasonal or cyclical activities – buy marketable securities with seasonal surpluses, convert securities back to cash when deficits occur
Planned or possible expenditures – accumulate marketable securities in anticipation of upcoming expenses

25. Figure 27.6

26. Marketable Securities
Microsoft 2008 cash investments

27. Minicase
Keafer Manufacturing working capital management

28. Homework 3 Due 15 Dec. Thursday 13:55 pm In RJW 9th ed.:
Chapter 26—Questions and problems : 12, 13;
Chapter 28—Questions and problems : 5, 16.