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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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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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