Chapter 16 Short-Term Financial Planning
Key Concepts and Skills <ul><li>Be able to compute the operating and cash cycles and understand why they are important </l...
Chapter Outline <ul><li>Tracing Cash and Net Working Capital </li></ul><ul><li>The Operating Cycle and the Cash Cycle </li...
Sources and Uses of Cash <ul><li>Sources of Cash </li></ul><ul><ul><li>Obtaining financing: </li></ul></ul><ul><ul><ul><li...
The Operating Cycle <ul><li>The time it takes to receive inventory, sell it, and collect on the receivables generated from...
The Cash Cycle <ul><li>The time between payment for inventory and receipt from the sale of inventory </li></ul><ul><li>Cas...
Table 16.1
Example Information Net Sales = $1,150,000 Cost of Goods Sold = $820,000 87,500 100,000 75,000 Accounts Payable 180,000 20...
Example: Operating Cycle <ul><li>Inventory period </li></ul><ul><ul><li>Average inventory = (200,000+300,000)/2 = 250,000 ...
Example: Cash Cycle <ul><li>Accounts Payable Period = 365 / payables turnover </li></ul><ul><ul><li>Payables turnover = CO...
Short-Term Financial Policy <ul><li>Flexible (Conservative) Policy </li></ul><ul><ul><li>Large amounts of cash and marketa...
Carrying versus Shortage Costs <ul><li>Carrying costs </li></ul><ul><ul><li>Opportunity cost of owning current assets vers...
Temporary versus Permanent Assets <ul><li>Are current assets temporary or permanent? </li></ul><ul><ul><li>Both! </li></ul...
Figure 16.4
Choosing the Best Policy <ul><li>Best policy will be a combination of flexible and restrictive policies </li></ul><ul><li>...
Figure 16.5
Cash Budget <ul><li>Primary tool in short-run financial planning </li></ul><ul><ul><li>Identify short-term needs and poten...
Example: Cash Budget Information <ul><li>Expected Sales by quarter (millions) </li></ul><ul><ul><li>Q1: $57; Q2: $66; Q3: ...
Example: Cash Budget – Cash Collections 30 22 22 19 Ending Receivables = 1/3(Sales) 82 66 63 68 Cash Collections = Beg. Re...
Example: Cash Budget – Cash Disbursements 72.50 54.50 89.50 47.75 Total Disbursements 5.00 5.00 5.00 5.00 Long-term financ...
Example: Cash Budget – Net Cash Flow and Cash Balance 10.25 (1.25) 25.25 5.00 Beginning Cash Balance 9.50 11.50 (26.50) 20...
Short-Term Borrowing <ul><li>Unsecured loans </li></ul><ul><ul><li>Line of credit – prearranged agreement with a bank that...
Example: Factoring <ul><li>Selling receivables to someone else at a discount </li></ul><ul><li>Example: You have an averag...
Short-Term Financial Plan 0.00 0.00 3.25 0.00 Ending Short-Term Debt 0.00 -3.25 3.25 0.00 Change in Short-Term Debt 0.00 3...
Quick Quiz <ul><li>Suppose your average inventory is $10,000, your average receivables balance is $9,000, and your average...
Comprehensive Problem <ul><li>With average accounts receivable of $5 million, and credit sales of $24 million, you factor ...
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Ross, Chapter 16: Short Term Financial Planning

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  • Use this table as motivation for why non-finance majors need to understand short-term financial management
  • Note that we are assuming that all sales are credit sales. So, on average it takes 168 days from the time we receive the inventory to sell it and collect on the sale .
  • Point out that these two policies are the extremes. Most companies will be somewhere in between. What are advantages and disadvantages of a flexible policy? Advantages – you should not have difficulty meeting short-term obligations, and you have cash on hand for emergencies or unexpected opportunities; lower shortage costs Disadvantages – liquid securities generally do not offer as high a return as long-term assets (opportunity cost of liquidity), financing short-term assets with long-term debt can be dangerous if you run into an economic downturn (you sell less inventory and you may have too much on hand, accounts receivable defaults may increase and you still have to pay off long-term debt); high carrying costs What are the advantages and disadvantages of the restrictive policy? Advantages – Higher investment in long-term assets generally provides a higher return; lower carrying costs; short-term liabilities can be decreased more easily than long-term liabilities in the case of an economic downturn Disadvantages – Less liquidity for emergencies or unexpected opportunities; higher shortage costs
  • A good example 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.
  • 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 and 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 due to uncertainty of interest rates and may not be able 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 rate 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.
  • ACP of 30 days implies that 2/3 of sales will be collected in quarter sold, 1/3 will be collected the following quarter Payables period of 45 days implies that payables will be paid in the quarter the inventory is ordered
  • Based on these estimates, the company will need to borrow money in the second quarter to help fund the capital expansion. Depending on the firm’s financial policy, it can borrow the funds either short-term or long-term. Given the cash surplus in Q3 and Q4, the firm would probably want to borrow on a short-term basis because there will be ample cash (assuming forecasts are reasonably accurate) in Q3 to repay the loan.
  • Factoring with a discount of 2.5% means that you sell the receivables for 97.5 cents on the dollar. Factoring is often a relatively expensive form of financing. Ask the students the following questions to see if they see the relationship between the cost of financing and the various terms of the agreement: Will the cost be higher or lower if the receivables are discounted at 3%? (higher: EAR = 44.125%) Will the cost be higher or lower if the receivables turnover was 9? (lower: EAR = 25.59%) The choice of the discount will often depend on the company’s receivables turnover – the longer it takes to collect on the receivables, the greater the risk to the purchaser of the receivables, the larger the discount will be.
  • Assume that the interest rate on short-term debt is an APR of 24% (24/4 = 6% per quarter) Technically the interest in Q3 is 3.25(.06) = .195. It was rounded for presentation purposes.
  • Inventory turnover = 50,000 / 10,000 = 5 times Inventory period = 365 / 5 = 73 days Receivables turnover = 100,000 / 9,000 = 11.11 times Average collection period = 365 / 11.11 = 33 days Payables turnover = 50,000 / 4,000 = 12.5 times Payables period = 365 / 12.5 = 29 days Operating Cycle = 73 + 33 = 106 days Cash Cycle = 106 days – 29 days = 77 days
  • Receivables turnover = $24/$5 = 4.8 times APR = 4.8(.02/.98) = .09796 = 9.8%
  • Ross, Chapter 16: Short Term Financial Planning

    1. 1. Chapter 16 Short-Term Financial Planning
    2. 2. Key Concepts and Skills <ul><li>Be able to compute the operating and cash cycles and understand why they are important </li></ul><ul><li>Understand the different types of short-term financial policy </li></ul><ul><li>Understand the essentials of short-term financial planning </li></ul>
    3. 3. Chapter Outline <ul><li>Tracing Cash and Net Working Capital </li></ul><ul><li>The Operating Cycle and the Cash Cycle </li></ul><ul><li>Some Aspects of Short-Term Financial Policy </li></ul><ul><li>The Cash Budget </li></ul><ul><li>Short-Term Borrowing </li></ul><ul><li>A Short-Term Financial Plan </li></ul>
    4. 4. Sources and Uses of Cash <ul><li>Sources of Cash </li></ul><ul><ul><li>Obtaining financing: </li></ul></ul><ul><ul><ul><li>Increase in long-term debt </li></ul></ul></ul><ul><ul><ul><li>Increase in equity </li></ul></ul></ul><ul><ul><ul><li>Increase in current liabilities </li></ul></ul></ul><ul><ul><li>Selling assets </li></ul></ul><ul><ul><ul><li>Decrease in current assets </li></ul></ul></ul><ul><ul><ul><li>Decrease in fixed assets </li></ul></ul></ul><ul><li>Uses of Cash </li></ul><ul><ul><li>Paying creditors or stockholders </li></ul></ul><ul><ul><ul><li>Decrease in long-term debt </li></ul></ul></ul><ul><ul><ul><li>Decrease in equity </li></ul></ul></ul><ul><ul><ul><li>Decrease in current liabilities </li></ul></ul></ul><ul><ul><li>Buying assets </li></ul></ul><ul><ul><ul><li>Increase in current assets </li></ul></ul></ul><ul><ul><ul><li>Increase in fixed assets </li></ul></ul></ul>
    5. 5. The Operating Cycle <ul><li>The time it takes to receive inventory, sell it, and collect on the receivables generated from the sale of the inventory </li></ul><ul><li>Operating cycle = inventory period + accounts receivable period </li></ul><ul><ul><li>Inventory period = time inventory sits on the shelf </li></ul></ul><ul><ul><li>Accounts receivable period = time it takes to collect on receivables </li></ul></ul>
    6. 6. The Cash Cycle <ul><li>The time between payment for inventory and receipt from the sale of inventory </li></ul><ul><li>Cash cycle = operating cycle – accounts payable period </li></ul><ul><ul><li>Accounts payable period = time between receipt of inventory and payment for it </li></ul></ul><ul><li>The cash cycle measures how long we need to finance inventory and receivables </li></ul>
    7. 7. Table 16.1
    8. 8. Example Information Net Sales = $1,150,000 Cost of Goods Sold = $820,000 87,500 100,000 75,000 Accounts Payable 180,000 200,000 160,000 Accounts Receivable 250,000 300,000 200,000 Inventory Average Ending Beginning Item
    9. 9. Example: Operating Cycle <ul><li>Inventory period </li></ul><ul><ul><li>Average inventory = (200,000+300,000)/2 = 250,000 </li></ul></ul><ul><ul><li>Inventory turnover = 820,000 / 250,000 = 3.28 times </li></ul></ul><ul><ul><li>Inventory period = 365 / 3.28 = 111 days </li></ul></ul><ul><li>Receivables period </li></ul><ul><ul><li>Average receivables = (160,000+200,000)/2 = 180,000 </li></ul></ul><ul><ul><li>Receivables turnover = 1,150,000 / 180,000 = 6.39 times </li></ul></ul><ul><ul><li>Receivables period = 365 / 6.39 = 57 days </li></ul></ul><ul><li>Operating cycle = 111 + 57 = 168 days </li></ul>
    10. 10. Example: Cash Cycle <ul><li>Accounts Payable Period = 365 / payables turnover </li></ul><ul><ul><li>Payables turnover = COGS / Average AP </li></ul></ul><ul><ul><ul><li>PT = 820,000 / 87,500 = 9.4 times </li></ul></ul></ul><ul><ul><li>Accounts payables period = 365 / 9.4 = 39 days </li></ul></ul><ul><li>Cash cycle = 168 – 39 = 129 days </li></ul><ul><li>So, we have to finance our inventory and receivables for 129 days </li></ul>
    11. 11. Short-Term Financial Policy <ul><li>Flexible (Conservative) Policy </li></ul><ul><ul><li>Large amounts of cash and marketable securities </li></ul></ul><ul><ul><li>Large amounts of inventory </li></ul></ul><ul><ul><li>Liberal credit policies (large accounts receivable) </li></ul></ul><ul><ul><li>Relatively low levels of short-term liabilities </li></ul></ul><ul><li>High liquidity </li></ul><ul><li>Restrictive (Aggressive) Policy </li></ul><ul><ul><li>Low cash and marketable security balances </li></ul></ul><ul><ul><li>Low inventory levels </li></ul></ul><ul><ul><li>Little or no credit sales (low accounts receivable) </li></ul></ul><ul><ul><li>Relatively high levels of short-term liabilities </li></ul></ul><ul><li>Low liquidity </li></ul>
    12. 12. Carrying versus Shortage Costs <ul><li>Carrying costs </li></ul><ul><ul><li>Opportunity cost of owning current assets versus long-term assets that pay higher returns </li></ul></ul><ul><ul><li>Cost of storing larger amounts of inventory </li></ul></ul><ul><li>Shortage costs </li></ul><ul><ul><li>Order costs – the cost of ordering additional inventory or transferring cash </li></ul></ul><ul><ul><li>Stock-out costs – the cost of lost sales due to lack of inventory, including lost customers </li></ul></ul>
    13. 13. Temporary versus Permanent Assets <ul><li>Are current assets temporary or permanent? </li></ul><ul><ul><li>Both! </li></ul></ul><ul><li>Permanent current assets refer to the level of current assets that the company retains regardless of any seasonality in sales </li></ul><ul><li>Temporary current assets refer to the additional current assets that are added when sales are expected to increase on a seasonal basis </li></ul>
    14. 14. Figure 16.4
    15. 15. Choosing the Best Policy <ul><li>Best policy will be a combination of flexible and restrictive policies </li></ul><ul><li>Things to consider </li></ul><ul><ul><li>Cash reserves </li></ul></ul><ul><ul><li>Maturity hedging </li></ul></ul><ul><ul><li>Relative interest rates </li></ul></ul><ul><li>Compromise policy – borrow short-term to meet peak needs, and maintain a cash reserve for emergencies </li></ul>
    16. 16. Figure 16.5
    17. 17. Cash Budget <ul><li>Primary tool in short-run financial planning </li></ul><ul><ul><li>Identify short-term needs and potential opportunities </li></ul></ul><ul><ul><li>Identify when short-term financing may be required </li></ul></ul><ul><li>How it works </li></ul><ul><ul><li>Identify sales and cash collections </li></ul></ul><ul><ul><li>Identify various cash outflows </li></ul></ul><ul><ul><li>Subtract outflows from inflows and determine investing and financing needs </li></ul></ul>
    18. 18. Example: Cash Budget Information <ul><li>Expected Sales by quarter (millions) </li></ul><ul><ul><li>Q1: $57; Q2: $66; Q3: $66; Q4: $90 </li></ul></ul><ul><li>Beginning Accounts Receivable = $30 </li></ul><ul><li>Average collection period = 30 days </li></ul><ul><li>Purchases from suppliers = 50% of next quarter’s estimated sales </li></ul><ul><li>Accounts payable period = 45 days </li></ul><ul><li>Wages, taxes, and other expenses = 25% of sales </li></ul><ul><li>Interest and dividends = $5 million per quarter </li></ul><ul><li>Major expansion planned for quarter 2 costing $35 million </li></ul><ul><li>Beginning cash balance = $5 million with minimum cash balance of $2 million </li></ul>
    19. 19. Example: Cash Budget – Cash Collections 30 22 22 19 Ending Receivables = 1/3(Sales) 82 66 63 68 Cash Collections = Beg. Receivables + 2/3(Sales) 90 66 66 57 Sales 22 22 19 30 Beginning Receivables Q4 Q3 Q2 Q1
    20. 20. Example: Cash Budget – Cash Disbursements 72.50 54.50 89.50 47.75 Total Disbursements 5.00 5.00 5.00 5.00 Long-term financing (interest and dividends) 35.00 Capital Expenditures 22.50 16.50 16.50 14.25 Wages, taxes, other expenses 45.00 33.00 33.00 28.50 Payment of A/P = 50% of sales Q4 Q3 Q2 Q1
    21. 21. Example: Cash Budget – Net Cash Flow and Cash Balance 10.25 (1.25) 25.25 5.00 Beginning Cash Balance 9.50 11.50 (26.50) 20.25 Net Cash Inflow 19.75 10.25 (1.25) 25.25 Ending Cash Balance 9.5 11.50 (26.50) 20.25 Net Cash Flow -2.00 -2.00 -2.00 -2.00 Minimum Cash Balance 17.75 8.25 (3.25) 23.25 Cumulative surplus (deficit) 72.50 54.50 89.50 47.75 Total Cash Disbursements 82.00 66.00 63.00 68.00 Total Cash Collections Q4 Q3 Q2 Q1
    22. 22. Short-Term Borrowing <ul><li>Unsecured loans </li></ul><ul><ul><li>Line of credit – prearranged agreement with a bank that allows the firm to borrow up to a certain amount on a short-term basis </li></ul></ul><ul><ul><li>Committed – formal legal arrangement that may require a commitment fee and generally has a floating interest rate </li></ul></ul><ul><ul><li>Non-committed – informal agreement with a bank that is similar to credit card debt for individuals </li></ul></ul><ul><ul><li>Revolving credit – non-committed agreement with a longer time between evaluations </li></ul></ul><ul><li>Secured loans – loan secured by receivables, inventory, or both </li></ul>
    23. 23. Example: Factoring <ul><li>Selling receivables to someone else at a discount </li></ul><ul><li>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. </li></ul><ul><li>What is the APR? </li></ul><ul><ul><li>Period rate = .025/.975 = 2.564% </li></ul></ul><ul><ul><li>APR = 12(2.564%) = 30.769% </li></ul></ul><ul><li>What is the effective rate? </li></ul><ul><ul><li>EAR = 1.02564 12 – 1 = 35.502% </li></ul></ul>
    24. 24. Short-Term Financial Plan 0.00 0.00 3.25 0.00 Ending Short-Term Debt 0.00 -3.25 3.25 0.00 Change in Short-Term Debt 0.00 3.25 000 0.00 Beginning Short-Term Debt 17.55 8.05 0.00 23.25 Cumulative Surplus (Deficit) -2.00 -2.00 -2.00 -2.00 Minimum Cash Balance 19.55 10.05 2.00 25.25 Ending Cash Balance 0.00 3.25 0.00 0.00 Short-Term Debt Repayment 0.00 0.20 0.00 0.00 Interest on Short-Term Debt 0.00 0.00 3.25 0.00 New Short-Term Debt 9.50 11.50 (26.50) 20.25 Net Cash Inflow 10.05 2.00 25.25 5.00 Beginning Cash Q4 Q3 Q2 Q1
    25. 25. Quick Quiz <ul><li>Suppose your average inventory is $10,000, your average receivables balance is $9,000, and your average payables balance is $4,000. Net sales are $100,000 and cost of goods sold is $50,000. </li></ul><ul><ul><li>What are the operating cycle and the cash cycle? </li></ul></ul><ul><li>What are the differences between flexible and restrictive short-term financial policies? </li></ul><ul><li>What factors do we need to consider when choosing a financial policy? </li></ul><ul><li>What factors go into determining a cash budget and why is it valuable? </li></ul>
    26. 26. Comprehensive Problem <ul><li>With average accounts receivable of $5 million, and credit sales of $24 million, you factor receivables by discounting them 2%. What is the effective rate of interest? </li></ul>
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