Chapter Eighteen ShortTerm Finance and Planning Prepared by

Chapter Eighteen Short-Term Finance and Planning Prepared by Anne Inglis, Ryerson University © 2003 The Mc. Graw-Hill Companies, Inc. All rights reserved.

18. 1 Key Concepts and Skills • Understand the components of the cash cycle and why it is important • Understand the pros and cons of the various short-term financing policies • Be able to prepare a cash budget • Understand the various options for short-term financing Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 2 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 A Short-Term Financial Plan Short-Term Borrowing Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 3 Sources and Uses of Cash 18. 1 • 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 – Increasing long-term debt, equity or current liabilities – Decreasing current assets other than cash or fixed assets • Uses – Decreasing long-term debt, equity or current liabilities – Increasing current assets other than cash or fixed assets Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 4 The Operating Cycle 18. 2 • 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 Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 5 The 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 Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 6 Figure 18. 1 – Cash Flow Time Line Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 7 Example Information • Inventory: – Beginning = 5000 – Ending = 6000 • Accounts Receivable: – Beginning = 4000 – Ending = 5000 • Accounts Payable: – Beginning = 2200 – Ending = 3500 • Net sales = 30, 000 (assume all sales are on credit) • Cost of Goods sold = 12, 000 Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 8 Example – 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 = 167 + 55 = 222 days Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 9 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 = 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 Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 10 Short-Term Financial Policy 18. 3 • Size of investments in current assets – Flexible policy – maintain a high ratio of current assets to sales – Restrictive policy – maintain a low ratio of current assets to sales • Financing of current assets – Flexible policy – less short-term debt and more long-term debt – Restrictive policy – more short-term debt and less long-term debt Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 11 Carrying vs. Shortage Costs • Managing short-term assets involves a tradeoff 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, lost customers and production stoppages Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 12 Figure 18. 2 – Carrying Costs and Storage Costs Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 13 Figure 18. 2 – Carrying Costs and Storage Costs Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 14 Temporary vs. Permanent Assets • Temporary current assets – Sales or required inventory build-up are often seasonal – The additional current assets 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 – These assets are considered “permanent” because the level is constant, not because the assets aren’t sold Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 15 Figure 18. 4 – Total Asset Requirement Over Time Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 16 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 Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 17 Choosing the Best Policy continued • Relative Interest Rates – Short-term rates are normally lower than longterm 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 Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 18 Figure 18. 6 – A Compromise Financing Policy Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 19 The Cash Budget 18. 4 • Forecast of cash inflows and outflows over the next short-term planning period • Primary tool in short-term financial planning • Helps determine when the firm should experience cash surpluses and when it will need to borrow to cover working-capital costs • Allows a company to plan ahead and begin the search for financing before the money is actually needed Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 20 Example: Cash Budget Information • Pet Treats Inc. specializes in gourmet pet treats and receives all income from sales • Sales estimates (in millions) – Q 1 = 500; Q 2 = 600; Q 3 = 650; Q 4 = 800; Q 1 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 25% of sales – Interest and dividend payments are $50 – A major capital expenditure of $300 is expected in the second quarter • The initial cash balance is $100 and the company maintains a minimum balance of $50. Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 21 Example: Cash Budget – Cash Collections • 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 Beginning Receivables Sales Cash Collections Ending Receivables Q 1 250 500 583 167 Q 2 167 600 567 200 Q 3 200 650 633 217 Q 4 217 800 750 267 Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 22 Example: Cash Budget – Cash Disbursements • 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 Q 1 Q 2 Payment of accounts 275 313 362 338 Wages, taxes and other expenses 125 150 163 200 Capital expenditures Interest and dividend payments Total cash disbursements Q 3 Q 4 300 50 50 450 813 575 588 Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 23 Example: Cash Budget – Net Cash Flow and Cash Balance Q 1 Q 2 Q 3 Q 4 Total cash collections 583 567 633 750 Total cash disbursements 450 813 575 588 Net cash inflow 133 -246 Beginning Cash Balance 100 233 -13 Net cash inflow 133 -246 58 162 Ending cash balance 233 -13 45 207 Minimum cash balance -50 -50 Cumulative surplus (deficit) 183 -63 58 162 45 -50 -5 157 Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 24 Short-Term Financial Plan • Suppose now that we take the interest on shortterm borrowing into account • Each quarter, the company repays capital and interest • Suppose the interest on short-term borrowing is 12% APR (3% per quarter) Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.

18. 25 Short-Term Financial Plan 18. 5 Q 1 Q 2 Q 3 Q 4 Beginning cash balance 100 233 50 50 Net cash inflow 133 -246 58 162 2 1 56 7 New short-term borrowing 63 Interest on short-term borrowing (12% APR) Short-term borrowing repaid Ending cash balance 233 50 50 204 Minimum cash balance -50 -50 Cumulative surplus (deficit) 183 0 0 154 63 7 Beginning short-term debt 0 Change in short-term debt 0 63 -56 -7 Ending short-term debt 0 63 7 0 Copyright © 2005 Mc. Graw-Hill Ryerson Limited. All rights reserved.