Chapter

Eighteen
Short-Term Finance
and Planning

2003 The McGraw-Hill Companies, Inc. All rights

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

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18.3

Sources and Uses of Cash 18.1

Net Working Capital Management: management of the firms CA
and CL. Will the firm have sufficient cash to pay its bills?

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

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18.4

The Operating Cycle 18.2

Operating cycle time period between the

acquisition of inventory and the collection of A/Rs

Inventory period time required to purchase and
sell the inventory
Accounts receivable period time to collect on
credit sales (time between sale of inventory and
collection of A/R)

Operating cycle = inventory period + accounts

receivable period

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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
Time between the payment for inventory and the receipt of
A/R

Accounts payable period time between purchase of

inventory and payment for the inventory
Cash cycle = Operating cycle accounts payable
period

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18.6

Figure 18.1 Cash Flow Time Line

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18.7

Notes
Inventory period = 365 / Inv. Turnover
= 365 (Avg. Inv.) / COGS

Receivables Collection Period = 365 / A/R Turnover

= 365 (Avg. A/R) / Credit Sales

Payables Deferral Period = 365 / Payables Turnover

= 365 (Avg. A/P) / COGS

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18.8

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
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18.9

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

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18.10

Example Cash Cycle

Payables Period
Average payables = (2200 + 3500)/2 = 2850
Payables turnover = 12,000/2850 = 4.21 times
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

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18.11

Short-Term Financial Policy 18.3

Size of investments in current assets
Flexible policy maintain a high ratio of current assets to
sales (hold a lot of CA i.e., very liquid & low profit)
Restrictive policy maintain a low ratio of current assets
to sales (hold few CA i.e., low liquidity & high profit)

Financing of current assets

Flexible policy less short-term debt and more long-term
debt
Restrictive policy more short-term debt and less longterm debt

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18.12

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 (eg. Interest), 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 & stock out costs
Costs related to safety reserves, i.e., lost sales, lost
customers and production stoppages

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18.13

Figure 18.2 Carrying Costs and Shortage Costs

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18.14

Figure 18.2 Carrying Costs and Shortage Costs

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18.15

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 arent sold

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18.16

Figure 18.4 Total Asset Requirement Over Time

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18.17

Total Asset Requirement Over Time (cont.)

Restrictive Policy- Short-term financing is used for
seasonal CAs only (i.e., more interest rate risk & higher
profit)

Flexible Policy- Finance all assets with long-term debt and

equity (i.e., less interest rate risk & lower returns)

Compromise (Moderate) Policy- Finance all fixed assets,

permanent CAs plus some seasonal CAs with long-term
financing (i.e., moderates interest rate risk & profit)

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18.18

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
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18.19

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
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18.20

Figure 18.6 A Compromise Financing Policy

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18.21

The Cash Budget 18.4

Cash Budget- examines all expected inflows and
outflows of cash for a number of periods into the
future
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
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18.22

Example: Cash Budget Information

It is December 1, 2006. A firm expects sales estimates over
the next four months to be as follows:
December = $150,000, January = $60,000, February =
$70,000, March = $75,000.
Sales in October and November were $80,000 and $100,000
respectively.
Twenty percent of these sales are cash, 30% are paid one
month after sales, and 50 % are paid two months after sale. A
2% discount is given for accounts paid in the first month after
sale.
The firm purchases inventory of 60% of next months
expected sales for cash.
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18.23

Example: Cash Budget Information (cont.)

Wages are $40,000 per month and depreciation is $10,000 per
month.
Taxes of $80,000 will be paid in January.
The firm will sell $4,000 in stock in February.
Currently, $5,000 of cash is on hand. A minimum balance of
$10,000 is required.
Complete a cash budget for December, January, and February.

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18.24

Short-Term Borrowing 18.6

Line of Credit- a formal (committed) or informal
(uncommitted) prearranged short-term bank loan letting the
borrower borrow up to a specified amount over a specified
period of time
Letter of credit- a written statement by a bank that money will
be paid, provided conditions specified in the letter are met.
Covenants- a promise by the firm included, in the debt
contract, to perform certain acts (e.g., restrictions of further
debt and limits on dividends)
Secured loan- assets back the loan
Unsecured loan- no assets backing the loan
Inventory Loans- a secured short-term loan to purchase
inventory.

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18.25

Covenants
Protective Covenants
Negative covenants things the borrower agrees not to do

Agrees to limit the amount of dividends paid

Agree not to pledge assets to other lenders
Agree not to merge with, sell to or acquire another firm
Agree not to buy new capital assets above $x in value
Agree not to issue new debt

Positive covenants things the borrower agrees to do

Maintain a minimum current ratio
Provide audited financial statements
Maintain collateral in good condition

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18.26

Example: Compensating Balance

We have a $500,000 operating loan with a 15%
compensating balance requirement. The quoted
interest rate is 9%. We need to borrow $150,000 for
inventory for one year.

Note: A Compensating Balance is some of the firms money kept by the

bank in low-interest or no-interest bearing accounts. This will increase the
effective interest rate earned by the bank, thereby compensating the bank.

How much do we need to borrow?

150,000/(1-.15) = 176,471
What interest rate are we effectively paying?
Interest paid = 176,471(.09) = 15,882
Effective rate = 15,882/150,000 = .1059 or 10.59%
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18.27

Factoring
EAR = [ 1 + {discount / (1 discount)}^(365/ACP) 1
The A/Rs are sold at a discount and the borrower is not
responsible for the default of the A/Rs (i.e., A/R financing)
A factor is an independent company that acts as an outside
credit department for the client. It checks the credit of new
customers, authorizes credit, handles collection and
bookkeeping.
The legal arrangement is that the factor purchases the A/R
from the firm. Thus, factoring provides insurance against bad
debts because any defaults on bad accounts are the factors
problem.

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18.28

Example: Factoring
Last year your company had average accounts
receivable of $2 million. Credit sales were $24
million. You factor receivables by discounting
them 2%. What is the effective rate of
interest?
A/R turnover ratio= 24/2 = 12 times
Average collection period = 365/12 = 30.4 days
EAR = (1+.02/.98)365/30.4 1 = .2743 or 27.43%

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