1. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Short-Term Financial Planning Chapter 16

2. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.1 Chapter Outline 1. Sources and Uses of Cash 2. The Operating Cycle and Cash Cycle 3. Calculate Operating Cycle and Cash Cycle 4. Managers in Short-term Financing 5. Short-Term Financial Policy 6. Cash Budget 7. Short-Term Borrowing

3. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.2 1.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 Cash + Current Asset other than cash + Fixed Assets = Current Liabilities + Long-term debt + Equity

4. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.3 Sources and Uses of Cash Illustration Cash + Current Asset other than cash + Fixed Assets = Current Liabilities + Long-term debt + Equity

5. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.4 2.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

6. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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

7. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.6 Operating and Cash Cycle Illustration Inventory purchased Inventory periodAccounts receivable period Cash paid for inventory Inventory sold Cash received Cash cycleAccounts payable period 30%

8. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.7 3.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

9. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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 = 111 + 57 = 168 days

10. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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

11. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.10 4.Managers in Short-term Financing

12. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.11 5.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 Wants to avoid losing business because of shortage of resources 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 Wants to avoid wasting resources

13. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.12 Carrying versus Shortage Costs Shortage costs (increase when current assets decrease) 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 Carrying costs (increase when current assets increase) Opportunity cost of owning current assets versus long- term assets that pay higher returns Cost of storing larger amounts of inventory

14. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.13 Choosing the Best Policy Best policy will be a combination of flexible and restrictive policies Compromise policy – borrow short-term to meet peak needs, maintain a cash reserve for emergencies 50%

15. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.14 6.Cash Budget Primary tool in short-run financial planning 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

16. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.15 Example: Cash Budget Information Expected Sales for 2005 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 current quarter’s estimated sales, at the beginning of each quarter 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 Minimum cash balance requirement = $2 million

17. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.16 Example: Cash Budget Step 1: Cash Collections Q1Q2Q3Q4 Beginning Receivables301922 Sales5766 90 Cash Collections = Beg. Receivables + 2/3(Sales) 68636682 Ending Receivables = 1/3(Sales) 1922 30

18. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.17 Example: Cash Budget Step 2: Cash Disbursements Q1Q2Q3Q4 Payment of A/P = 50% of sales 28.5033.00 45.00 Wages, taxes, other expenses 14.2516.50 22.50 Capital Expenditures35.00 Long-term financing (interest and dividends) 5.00 Total Disbursements47.7589.5054.5072.50 75%

19. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.18 Example: Cash Budget Step 3: Net Cash Flow and Cash Balance Q1Q2Q3Q4 Total Cash Collections68.0063.0066.0082.00 Total Cash Disbursements47.7589.5054.5072.50 Net Cash Flow20.25(26.50)11.509.5 Beginning Cash Balance5.0025.25(1.25)10.25 Net Cash Inflow20.25(26.50)11.509.50 Ending Cash Balance25.25(1.25)10.2519.75 Minimum Cash Balance-2.00 Cumulative surplus (deficit)23.25(3.25)8.2517.75

20. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.19 Things to Consider in Cash Budgeting Cash reserve more important for firms with unexpected opportunities on a regular basis, less important for firms in stable business Maturity hedging Avoid financing long-term assets with short-term securities Relative interest rates Long-term rates are normally higher, you don’t want to rely on higher interest debt to finance temporary short-term assets

21. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.20 7. 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

22. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.21 Short-Term Financial Plan Q1Q2Q3Q4 Beginning Cash5.0025.252.0010.05 Net Cash Inflow20.25(26.50)11.509.50 New Short-Term Debt0.003.250.00 Interest on Short-Term Debt0.00 0.200.00 Short-Term Debt Repayment0.00 3.250.00 Ending Cash Balance25.252.0010.0519.55 Minimum Cash Balance-2.00 Cumulative Surplus (Deficit)23.250.008.0517.55 Beginning Short-Term Debt0.00 3.250.00 Change in Short-Term Debt0.003.25-3.250.00 Ending Short-Term Debt0.003.250.00

23. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.22 Review Questions 1.What kind of activity is a source of cash and what kind of activity is a use of cash? 2.What is operating cycle? What is cash cycle? How cash cycle will be affected by changes in inventory period/turnover, accounts receivable period/turnover, and accounts payable period/turnover? 3.Know how to calculate operating cycle and cash cycle given information on sales, COGS, inventory, account receivable, and account payable.

24. McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 16.23 Review Questions (cont..) 5.What are the differences between flexible and restrictive short-term financial policies? What are carrying costs and shortage costs? 7.What are the short-term borrowing options? 100%