1. Short-term financial planning
Chapter 16

2. 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
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

3. 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
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

4. Net working capital (NWC) review
NWC + Fixed assets = L/T debt + Equity
NWC = (Cash + Other current assets) – Current liabilities
Cash = L/T debt + Equity + Current liabilities – Current assets other than cash – Fixed assets
L/T debt = Long-term debt
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

5. 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 shareholders
Decrease in long-term debt
Decrease in equity
Decrease in current liabilities
Buying assets
Increase in current assets
Increase in fixed assets
Notice that our two lists are exact opposites. For example, floating a long-term bond issue increases cash (at least until the money is spent). Paying off a long-term bond issue decreases cash.
Activities that increase cash are called sources of cash. Activities that decrease cash are called uses of cash.
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

6. 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 = the time inventory sits on the shelf
Accounts receivable period = the time it takes to collect on receivables
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7. Operating cycle equations
Operating cycle = Inventory period + Accounts receivable period
Inventory period = 365/Inventory turnover
Inventory turnover = Cost of goods sold/Average inventory
Accounts receivable period = 365/Receivables turnover
Average collection period
Accounts receivable turnover = Credit sales/Average accounts receivable
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

8. 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
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

9. Cash cycle equations
Cash cycle = Operating Cycle – Accounts payable period
Accounts payable period = 365/Payables turnover
Payables turnover = Cost of goods sold/Average accounts payable
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

10. The operating and cash cycles Figure 16.1
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

11. Managers who deal with short-term financial problems—Table 16.1
Use this table as motivation for why non-finance majors need to understand short-term financial management.
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

12. Example information
Operating Cycle = Inventory Period + Accounts Receivables Period
Inventory Period = 365/Inventory Turnover
Accounts Receivables Period = 365/Receivables Turnover
= Average Collection Period
Cash Cycle = Operating Cycle – Accounts Payable Period
Accounts Payable Period = 365/Payables Turnover
The data is the same as in the textbook.
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

13. Operating cycle—Example
Inventory period
Average inventory = ( )/2 =
Inventory turnover = / = 3.28 x
Inventory period = 365 / 3.28 = 111 days
Receivables period
Average receivables = ( )/2 =
Receivables turnover = / = 6.39 x
Receivables period = 365 / 6.39 = 57 days
Operating cycle = = 168 days
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

14. Cash cycle—Example Accounts payable period = 365 / payables turnover
Payables turnover = COGS / Average AP
PT = / = 9.4 x
Accounts payables period = 365 / 9.4 = 39 days
Cash cycle = 168 – 39 = 129 days
Inventory and receivables must be financed for 129 days
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

15. 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
Point out that these two policies are the extremes. Most companies will be somewhere in between.
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

16. Flexible financial policy
Advantages
No difficulty meeting short-term obligations
Cash available for emergencies
Lower storage costs
Disadvantages
Liquid securities = lower return
Financing short-term assets with long-term debt risky
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

17. Restrictive financial policy
Advantages
Higher returns on long-term assets
Lower carrying costs
Short-term liabilities can be decreased more easily in event of economic downturn
Disadvantages
Less liquidity for emergencies
Higher storage costs
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

18. Carrying vs 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 owing to lack of inventory, including lost customers
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

19. Temporary vs 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
A good way to help students see the difference between temporary and permanent assets is a discussion of retail stores and the different levels of inventory that they carry during the summer versus during the Christmas season.
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

20. Alternative asset financing policies Figure 16.4
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

21. 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
Cash reserves
More important when a firm has unexpected opportunities on a regular basis or in areas where financial distress is a strong possibility
Less important in stable industries
Zero NPV investments at best and an excess of cash (and marketable securities) will hurt the firm’s return (investors are often very unhappy with excess cash reserves)
Maturity hedging
It may make sense to try to match liabilities to the maturity of the assets (how long you expect to require the assets)
Maturity matching would involve financing fixed assets and permanent current assets with long-term debt and temporary current assets with current liabilities
Avoid financing long-term assets with short-term securities—involves refinancing on a regular basis owing to uncertainty of interest rates and it may not be possible to get refinancing if the firm runs into trouble
Relative interest rates
Long-term rates are normally (but not always) higher; therefore you don’t want to rely on higher interest debt to finance temporary short-term assets. The return on the short-term assets may not be enough to cover the cost of the debt.
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

22. A compromise financing policy Figure 16.5
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

23. Cash budget Primary tool in short-run financial planning How it works
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
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

24. Cash budget example Fun Toys Corporation
Expected sales by quarter (millions)
Q1: $200; Q2: $300; Q3: $250; Q4: $400
Beginning accounts receivable = $120
Collections = Beginning receivables + ½ x Sales
Accounts payable = 60% of sales
Wages, taxes and other expenses = 20% of sales
Interest and dividends = $20 million per quarter
Major expansion planned for quarter 2 costing $100 million
Beginning cash balance = $20 million with minimum cash balance of $10 million
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

25. Fun Toys Corporation Cash collections and cash disbursements
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

26. Fun Toys Corporation Net cash flow and cash balance
Comments on Fun Toys cash budget
Beginning in Q2, Fun Toys will have a cash deficit which must be covered
Sales are forecasts and reality could be much better or worse
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

27. 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
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

28. Short-term borrowing Secured loans
Secured loans—loan secured by receivables or inventory or both
Accounts receivable financing
Assigning receivables
Lender has A/R as security but borrower still responsible for collection
Factoring receivables
A/R discounted and sold to a factor
Collection = factor’s problem
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

29. Short-term borrowing Secured loans (cont.)
Inventory loans
Blanket inventory lien
Lender has lien against all inventories
Trust receipt
Borrower holds specific inventory in ‘trust’ for the lender
Auto dealer ‘floor plans’
Field warehouse financing
Public warehouse acts as control agent to supervise inventory for lender
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

30. Fun Toys Corporation Short-term financial plan
Deficit covered with S/T borrowing at 20% APR calculated quarterly
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

31. Quick quiz What is the operating cycle and the cash cycle?
Suppose your average inventory is $10 000, your average receivables are $9000 and your average payables are $4000. Net sales are $ and cost of goods sold is $
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?
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

32. Quick quiz—Solution Q1 Inventory turnover = 50 000 / 10 000 = 5 x
Inventory period = 365 / 5 = 73 days
Receivables turnover = / 9000 = 11.11x
Average collection period = 365 / = 33 days
Payables turnover = / 4000 = 12.5 x
Payables period = 365 / 12.5 = 29 days
Operating cycle = = 106 days
Cash cycle = 106 days – 29 days
= 77 days
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

33. Chapter 16
END