1. Short-Term Finance and Planning Chapter Sixteen

2. 1Barton College Why Skip to Chapter 16 Large Capital Budgeting decisions, while important, are made less frequently than short term NWC decisions. A mistake with short term budgeting decision can very quickly lead to insolvency. More (but not all) students will be exposed to short- term cash flow issues as opposed to long-term budgeting questions or issues. Many students start their careers working with short term cash budgeting areas: –Accounts Receivable, Accounts Payable, procurement, etc.

3. 2Barton College 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

4. 3Barton College 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

5. 4Barton College Sources and Uses of Cash Cash flows in and out of the corporation Balance sheet identity (rearranged) –Net working capital + fixed assets = long-term debt + equity –Net working capital = Cash + other CA – CL –Cash = long-term debt + equity + current liabilities – current assets other than cash – fixed assets Sources of Cash (Inflows) –Increasing long-term debt, equity or current liabilities –Decreasing current assets other than cash or fixed assets Uses of Cash (Outflows) –Decreasing long-term debt, equity or current liabilities –Increasing current assets other than cash or fixed assets We can use the following equation/identity to understand how cash increases or decreases. Cash + Other Current Assets + Fixed Assets = Current Liabilities + long-term debt + equity Cash = (Current Liabilities + long-term debt + equity) – (Other Current Assets + Fixed Assets)

6. 5Barton College Some Short-Run Operating and Financing Activities might Include Events 1.Buying Raw Material 2.Paying cash for purchases 3.Mfg the product 4.Selling the product 5.Collecting Cash Decisions 1.How much inventory to order? 2.To borrow or draw down cash balances? 3.What choice of production technology? 4.To offer cash terms or credit? 5.How to collect cash? All of these decisions involve understanding what is called the Operating Cycle

7. 6Barton College The Operating Cycle Operating cycle – time between purchasing the inventory and collecting the cash Inventory period – time required to purchase and sell the inventory Accounts receivable period – time to collect on credit sales Operating cycle = inventory period + accounts receivable period

8. 7Barton College Cash Cycle Cash cycle –time period for which we need to finance our inventory –Difference between when we receive cash from the sale and when we have to pay for the inventory Accounts payable period – time between purchase of inventory and payment for the inventory Cash cycle = Operating cycle – accounts payable period We can decrease the cash cycle: - Increase Accounts Payable cycle (Increase our credit) - Decrease Accounts Receivable cycle (Decrease their discounts)

9. 8Barton College Managers who deal with Short Term Financial Issues Cash Manager – Cash Securities, Short term loans, etc. Credit Manager – Accounts Receivable Marketing Manager – Accounts Receivable (Credit Policy) Purchasing Manager – Inventory Accounts Payable Production Manager – Inventory Accounts Payable Payables Manager – Accounts Payable Controller – Accounts Receivable and Accounts Payable

10. 9Barton College Figure 19.1

11. 10Barton College Example Cash Operating Cycles Dell’s low cash cycle comes from its superior supply chain management process. Amazon also has a very Low (negative) cash cycle

12. 11Barton College Example Information Inventory: –Beginning = 5000 –Ending = 6000 Accounts Receivable: –Beginning = 4000 –Ending = 5000 Accounts Payable: –Beginning = 2200 –Ending = 3500 Net sales = 30,000 Cost of Goods sold = 12,000 Given the following information calculate the operating and cash cycles

13. 12Barton College Example – Calculating Operating Cycle Inventory period –Average inventory = (5000 + 6000)/2 = 5500 –Inventory turnover = 12,000 / 5500 = 2.18 times –Inventory period = 365 / 2.18 = 167 days Receivables period –Average receivables = (4000 + 5000)/2 = 4500 –Receivables turnover = 30,000/4500 = 6.67 times –Receivables period = 365 / 6.67 = 55 days Operating Cycle = Inv. Period + Receivables Period Operating cycle = 167 + 55 = 222 days Inventory: –Beginning = 5000 –Ending = 6000 Accounts Receivable: –Beginning = 4000 –Ending = 5000 Accounts Payable: –Beginning = 2200 –Ending = 3500 Net sales = 30,000 Cost of Goods sold = 12,000 Data from Balance and Income Statements

14. 13Barton College Example – Cash Cycle Payables Period –Average payables = (2200 + 3500)/2 = 2850 –Payables turnover = 12,000/2850 = 4.21 –Payables period = 365 / 4.21 = 87 days Cash Cycle = Operating Cycle – payables period Cash Cycle = 222 – 87 = 135 days We have to finance our inventory for 135 days We need to be looking more carefully at our receivables and our payables periods – they both seem extensive Inventory: –Beginning = 5000 –Ending = 6000 Accounts Receivable: –Beginning = 4000 –Ending = 5000 Accounts Payable: –Beginning = 2200 –Ending = 3500 Net sales = 30,000 Cost of Goods sold = 12,000 Ultimately we want a small cash cycle window The smaller the window, the less the Demand on external financing… Data from Balance and Income Statements

15. 14Barton College What are some Short-Term Financial Policies Size of investments in current assets –Flexible policy – maintain a high ratio of current assets to sales Large cash and securities - (low return but cash available for emergencies and unexpected opportunities) Large Inventory – (higher carrying cost but lower shortage cost) Liberal credit terms – (Leads to greater probability of default but overall should generate higher sales) -Firm charges more (service or product) for the liberal credit terms…. –Restrictive policy – maintain a low ratio of current assets to sales Low cash and security balances Low levels of inventory Strict credit policy (Firm needs quick cash inflows to pay bills since it carries a low cash balance…) Financing of current assets –Flexible policy – less short-term debt and more long-term debt The longer the holding period of inventory, the more long-term debt should he used for financing. Short term debt can be volatile over the long run. –Restrictive policy – more short-term debt and less long-term debt Typically short debt is cheaper than long-term debt….

16. 15Barton College Carrying vs. Shortage Costs Managing short-term assets involves a trade-off between carrying costs and shortage costs –Carrying costs – increase with increased levels of current assets, the costs to store and finance the assets –Shortage costs – decrease with increased levels of current assets, the costs to replenish assets Trading or order costs Costs related to safety reserves, i.e., lost sales/goodwill and customers and production stoppage –The optimal investment in current assets is that which minimizes the sum of carrying and shortage costs.

17. 16Barton College Temporary vs. Permanent Assets Temporary current assets –Sales or required inventory build-up are often seasonal –Additional current assets are carried during the “peak” time –The level of current assets will decrease as sales occur Permanent current assets –Firms generally need to carry a minimum level of current assets at all times (They never actually reach zero..) Current ratio will usually be greater than 1 (Current Assets / Current Liabilities) –These assets are considered “permanent” because the level is constant, not because the assets aren’t sold

18. 17Barton College Total Asset Requirements over Time

19. 18Barton College Choosing the Best Policy Cash reserves –Pros – firms will be less likely to experience financial distress and are better able to handle emergencies or take advantage of unexpected opportunities –Cons – cash and marketable securities earn a lower return and are zero NPV investments Maturity hedging –Try to match financing maturities with asset maturities –Finance temporary current assets with short-term debt –Finance permanent current assets and fixed assets with long-term debt and equity One year loan/credit  current assets, inventory, etc 4-5 year loan  Auto, computer, machine, etc. 20 year loan  Building we match the loan to the asset maturity Interest Rates –Short-term rates are normally lower than long-term rates, so it may be cheaper to finance with short-term debt –Firms can get into trouble if rates increase quickly or if it begins to have difficulty making payments – may not be able to refinance the short-term loans Have to consider all these factors and determine a compromise policy that fits the needs of your firm

20. 19Barton College Compromise Financing Policy: Figure 19.6

21. 20Barton College 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

22. 21Barton College Example: Cash Budget Information Expected Sales 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

23. 22Barton College Example: Cash Budget – Cash Collections Q1Q2Q3Q4 Beginning Receivables301922 Sales5766 90 Cash Collections = Beg. Receivables + 2/3(Sales) 68636682 Ending Receivables = 1/3(Sales) 1922 30

24. 23Barton College Example: Cash Budget – 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

25. 24Barton College Example: Cash Budget – Net Cash Flow and Cash Balance Q1Q2Q3Q4 Total Cash Collections68.0063.0066.0082.00 Total Cash Disbursements 47.7589.5054.5072.50 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

26. 25Barton College 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

27. 26Barton College 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%) = 30.769% What is the effective rate? –EAR = 1.02564 12 – 1 = 35.502%

28. 27Barton College 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 Debt0.000003.250.00 Change in Short-Term Debt0.003.25-3.250.00 Ending Short-Term Debt0.003.250.00

29. 28Barton College 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 are 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?