Lecture 12

Short Term Financial Management

1
 Topics Covered
Long-Term and Short-Term Financing
Decisions
Tracing Changes in Cash
Cash Budgeting &Short-Term Financing Plan
Long-Term Financing Plan
Growth and External Financing

2
 Financial Planning: Need & Nature
A critical corporate treasury function is
Managing the companys cash flow/cash position
Finance deficits/ Invest or disburse surplus
Needs a cash forecast and a proposed course of action
A FINANCIAL PLAN
Short term and long term

3
 Short term & Long Term
Short-term financing decisions
Time value of money less critical
Decisions are more easily reversed
Eg. Overdraft v Bond issue
ST & LT financing linked
Total financing = ST + LT

4
 Idealised Financing Strategy
Dollars
Cumulative capital requirement
ST Finance

Permanent
Temporary Current assets
Current assets

LT finance
Fixed assets

Year 1 Year 2 Time

Perfect maturity matching

ST finance is self-liquidating

5
 Alternative Financing Strategies
Dollars A
Choice depends on
maturity matching
B & Uncertainty
C
Cumulative
capital requirement

Year 1 Year 2 Time

Lines A, B, and C show alternative amounts of long-term finance.

Strategy A: A permanent cash surplus

Strategy B: Short-term lender for part of year and borrower for
remainder (probably most common)
Strategy C: A permanent short-term borrower
6
 Balance Sheet
Example - Dynamic Mattress Company
Use of cash

2009 2008 2009 2008

Current assets: Current liabilities:
Cash 25 20 Bank loans 0 25
Marketable securities 25 0 Accounts payable 135 110
Accounts receivable 150 125 Total current liabilities 135 135
Inventory 125 130 Long-term debt 90 60
Total current assets 325 275 Net worth (equity and retained 350 320
Fixed assets: earnings)
Total liabilities and net worth 575 515
Gross investment 350 320
Less depreciation 100 80 Source of
Net fixed assets 250 240 cash
Total assets 575 515

7
 Income Statement
Example - Dynamic Mattress Company
1. Sales 2,200
2. Cost of goods sold 1,644
3. Other expenses 411
4. Depreciation 20
5. EBIT (1-2-3-4) 125
6. Interest 5
7 Pretax income (5-6) 120
8. Tax at 50% 60
9. Net income (7-8) 60

Dividend 30
Earnings retained in the business 30
8
 Changes in Cash Flows
Example -
HISTORY of cash flows Cash flows from operating activities:
Dynamic
Mattress
Company Net income 60
(Indirect Statement of
Cash Flow)
Depreciation 20
Decrease (increase) in accounts receivable -25
Decrease (increase) in inventories 5
Increase (decrease) in accounts payable 25
Net cash flow from operating activities 85

Cash flows from investing activities:

Investment in fixed assets -30

Cash flows from financing activities:

Dividends -30
Sale (purchase) of marketable securities -25
Increase (decrease) in long-term debt 30
Increase (decrease) in short-term debt -25
Net cash flow from financing activities -50

Increase (decrease) in cash balance 5

9
 Changes in Cash Flows
Example - Dynamic Mattress Company
Previous cash flow statement in words:
Dynamic sources of cash flows
1. It earned $60 million of net income (operating activity).
2. It set aside $20 million as depreciation. Remember that depreciation is
not a cash outlay. Thus, it must be added back in order to obtain
Dynamics cash flow (operating activity).
3. It reduced inventory, releasing $5 million (operating activity).
4. It increased its accounts payable, in effect borrowing an additional $25
million from its suppliers (operating activity).
5. It issued $30 million of long-term debt (financing activity).

10
 Changes in Cash Flows

Example - Dynamic Mattress Company

Dynamic uses of cash flows

1. It allowed accounts receivable to expand by $25 million (operating
activity). In effect, it lent this additional amount to its customers.
2. It invested $30 million (investing activity). This shows up as the increase
in gross fixed assets in Table 29.2.
3. It paid a $30 million dividend (financing activity). (Note: The $30 million
increase in Dynamics equity in Table 29.2 is due to retained earnings:
$60 million of equity income, less the $30 million dividend.)
4. It purchased $25 million of marketable securities (financing activity).
5. It repaid $25 million of short-term bank debt (financing activity)).

11
 Working Capital & Cash Cycle
UNDERSTANDING operating cash flows

Simple operating cash flow cycle (simple but

important)
Cash -ve

+ve

Receivables Raw materials

-ve -ve
Finished goods

Growing firms face a financing problem

12
 Cash Cycle Metrics
$inventory at start of year
Avg Days in Inventory = 29days
$annual COGS/365
Daily COGS

$receivabl es at start of year

Avg collection period = 21days
$annual sales/365

$payables at start of year

Avg payment period = 24days
$annual COGS/365
Average cash cycle 29 21 - 24 26 days

13
 Cash Budgeting
FUTURE Cash flows
Forecasting, planning and budgeting
Steps to preparing a cash budget
Step 1 - Forecast the sources of cash.
Step 2 - Forecast uses of cash.
Step 3 - Calculate whether the firm is facing a cash shortage
or surplus & when
Step 4 Decide what to do about 3
Financing or revise plans or both?

14
 Cash Budgeting
Example - Dynamic Mattress Company
START by Working out cash coming in
Forecast sources of cash
First forecast sales:

Next forecast collections from receivables

AR ending balance = AR beginning balance + sales -
collections

15
 Cash Budgeting
Example - Dynamic Mattress Company
Dynamic collections on accounts receivable (AR)
Second Fourth
First Quarter Third Quarter
Quarter Quarter
1. Receivables at start of period 150 199 181.6 253.6
2. Sales 560 502 742 836
3. Collections:
Sales in current period (70%) 392 351.4 519.4 585.2
Sales in last period (30%) 119* 168 150.6 222.6
Total collections 511 519.4 670 807.8
4. Receivables at end of period 1 + 2 - 3 199 181.6 253.6 281.8
* We assume that sales in the last quarter of the previous year were $397 million.

16
 Cash Budgeting
Example - Dynamic Mattress Company

Dynamic forecasted uses of cash

Payment of accounts payable
Labor, administration, and other expenses
Capital expenditures
Taxes, interest, and dividend payments

17
 Cash Budgeting
Sources of cash:

Example Collections on accounts receivable

Other (assumed eg. asset disposal)
511
0
519.4
0
670
77
807.8
0
Based on Total sources 511 519.4 747 807.8
forecast sales
Uses of cash:
and
Payments on accounts payable 250 250 267 261
production
Increase in inventory 150 150 170 180
budget Labor and other expenses 136 136 136 136
Based on Capital expenditures 70 10 8 14.5
capital budget Taxes, interest, and dividends 46 46 46 46

Total uses 652 592 627 637.5

Before allowing for
new financing Sources less uses (change in cash) -141 -72.6 120 170.3

Calculation of short-term borrowing requirement:

Cash at start of period 25 -116 -188.6 -68.6
Plus change in cash balance -141 -72.6 120 170.3
Cash at end of period -116 -188.6 -68.6 101.7
Plus minimum operating balance 25 25 25 25
Cumulative financing required 141 213.6 93.6 -76.7

18
 A Short Term Financing Plan
New borrowing: Q1 Q2 Q3 Q4
3. Develop plan by 1. Bank loan 100 0 0 0
trial & error to 2. Stretching payables 16 92.4 0 0
meet financing 3. Total 116 92.4 0 0
needs at 16. Repayments:
4. Review plan. 4. Bank loan 0 0 7.6 92.4
Use trial & error to 5. Stretching payables 0 16 92.4 0
develop a better 6. Total 0 16 100 92.4
plan 7. Net new borrowing 116 76.4 -100 -92.4
8. Plus securities sold 25 0 0 0
9. Less securities bought 0 0 12.4 75.3
10. Total cash raised 141 76.4 -112.4 -167.7
Cash required plus interest payments
11. Bank loan 0 2.5 2.5 2.3
1. Basic financing 12. Stretching payables (lost disc') 0 0.8 4.6 0
requirement . In 13. Interest on securities sold 0 0.5 0.5 0.3
this case it equals 14. Net interest cost 0 3.8 7.6 2.6
sources less uses
Cash required for operations -141 -72.6 120 170.3
2. Add cost of prior 16. Total cash required 141 76.4 -112.4 -167.7
quarters NEW
financing 19
 Is this a good plan?
Probably not stretching payables is expensive (lost
discounts)
What is the impact on financial condition
OK by year end

Would long term financing be better?

Could operating and other activities be
changed
Eg. defer capital expenditure, speed up collections
of receivables

20
 Tools for Analysing Financial Plans LT & ST

Spreadsheets and/or various purpose built or

commercial computer programs
Scenario Analysis
Simulation could be used, but probably isnt
Optimisation models eg. solver (often LP,
linear programming.)

21
 Financial Planning
Why Build Financial Plans?
Contingency planning
Eg. Growth slows, $ strengthens, interest rates up

Considering options
Eg. Creation of real options

Forcing consistency
Eg. Financial plans help managers ensure that their financial strategies are
consistent with their capital budgets. They highlight the financial decisions
necessary to support the firms production and investment goals.

22
 Financial Planning Steps
Inputs Planning Model Outputs

Inputs - Current financial statements. Forecasts of key variables (such as

sales or interest rates).

Planning Model - Equations specifying key relationships. % of sales method

is a simple starting point

Outputs - Projected financial statements (pro forma). Financial ratios.

Sources and uses of funds.

23
 Financial Planning Models
Pro Formas - Projected or forecasted financial
statements.
Percentage of Sales Model - Planning model in which
sales forecasts are the driving variable and most
other variables are proportional to sales.
Balancing Item - Variable that adjusts to maintain the
consistency of a financial plan.

24
Dynamic Mattress Financial Plan
2009 2008
Net working capital 190 140
Condensed year-end
Fixed assets: balance sheets for
Gross investment 350 320 2009 and 2008 for
Dynamic Mattress
Less accumulated depreciation 100 80 Company (figures in $
Net fixed assets 250 240 millions).
Total net assets 440 380
Long-term debt 90 60
Net worth (equity and retained earnings) 350 320
Long-term liabilities and net worth* 440 380

25
 Dynamic Mattress Financial Plan
Current and forecasted
operating cash flows for
Dynamic Mattress
Company (figures in $
millions).

2009 2010 2011 2012 2013 2014

1. Revenues 2200 2640 3168 3801.6 4561.9 5474.3
2. Costs (92% of revenues) 2055 2428.8 2914.6 3497.5 4197 5036.4
3. Depreciation (9% of net fixed assets at start of year) 20 22.5 29.7 35.6 42.8 51.3
4. EBIT (1-2-3) 125 188.7 223.7 268.5 322.2 386.6
5. Interest (10% of long-term debt at start of year) 5 9 23.4 31.8 42 54.3
6. Tax at 50% 60 89.8 100.1 118.3 140.1 166.2
7. Net income (4-5-6) 60 89.8 100.1 118.3 140.1 166.2

8. Operating cash flow (3+7) 80 112.4 129.8 154 182.9 217.5

26
Dynamic Mattress Financial Plan
2009 2010 2011 2012 2013 2014
Sources of capital:
1. Operating cash flow 80 112.4 129.8 154 182.9 217.5
( Net income plus depreciation)
Uses of capital:
2. Increase in net w orking capital (NWC)
assuming NWC = 11% of revenues 50 100.4 58.1 69.7 83.6 100.4
3. Investment in fixed assets (FA)
assuming net FA = 12.5% of revenues 30 102.5 95.7 114.8 137.8 165.4
4. Dividend (60% of net income) 30 53.9 60.1 71 84.1 99.7
5. Total uses of funds (2+3+4) 110 256.8 213.9 255.5 305.5 365.4

6. External capital required (1-5) 30 144.5 84 101.6 122.6 147.9

Current and forecasted

amounts of external capital
required for Dynamic
Mattress Company
(figures in $ millions).
27
Dynamic Mattress Financial Plan

2009 2010 2011 2012 2013 2014

Net working capital 190 290.4 348.5 418.2 501.8 602.2
Net fixed assets 250 330 396 475.2 570.2 684.3
Total net assets 440 620.4 744.5 893.4 1072.1 1286.5

Long-term debt 90 234.5 318.5 420 542.7 690.6

Equity 350 385.9 426 473.3 529.4 595.8
Total long-term liabilities and equity 440 620.4 744.5 893.4 1072.1 1286.5

Current and pro forma

balance sheets for
Dynamic Mattress
Company (figures in $
millions).
28
 Planners Beware
Percent of sales methods are not realistic eg.
because of lumpy nature of some costs (fixed
costs.)
Adjustments must be made to consider these
and other factors.
However, use a broad brush approach!

29
 Growth & External Financing
Internal growth rate - Rate at which a firm can grow without raising
external finance

retained earnings
Internal growth rate =
net assets
retained earnings net income equity
= x x
net income equity net assets
Sustainable growth rate - highest rate at which a firm can grow without changing
leverage

Sustainable growth rate = plowback ratio x return on equity g

30
 Topics Covered
Inventories
Credit Management
Cash
Marketable Securities
Sources of Short Term Borrowing

31
 Working Capital
Current assets and liabilities for U.S. manufacturing firms (1st qtr.
2009)$ billions

Currenty Assets Current Liabilities

Cash 273 Short-term loans 182

Other shirt-term financial
investments 147 Accounts payable 408

Accounts receivable 601 Accrued income taxes 27

Current payments due on
Inventories 626 long-term debt 131

Other current asets 348 Other current liabilities 768

Total 1996 Total 1517

32
 Working Capital
Current assets as a percentage of total assets in different
industries. Figures are the mean percentages for companies
in the S&P Composite Index in 2008.

33
 Inventory Management
Components of Inventory
Raw materials
Work in process
Finished goods

Goal = Minimize amount of cash tied up in inventory

Tools used to minimize inventory

Just-in-time
Lean manufacturing
 Inventories
As the firm increases its order size, the
number of orders falls and therefore the order
costs decline. However, an increase in order
size also increases the average amount in
inventory, so that the carrying cost of
inventory rises. The trick is to strike a balance
between these two costs.

35
 Managing Inventories

Inventory
10
Inventory, thousands of units

5 Average
Inventory

0 2 4 6 8

Weeks

36
 Inventories
Determination of optimal order size
Total costs
Inventory costs, dollars

Carrying costs

Total order costs

Optimal Order size

order size

37
 Inventories
Economic Order Quantity - Order size that minimizes
total inventory costs.

2 x annual sales x cost per order

Economic Order Quantity =
carrying cost

38
 Terms of Sale
Terms of Sale - Credit, discount, and payment terms
offered on a sale.

Example - 5/10 net 30

5 - percent discount for early payment

10 - number of days that the discount is available
net 30 - number of days before payment is due

39
 Terms of Sale
A firm that buys on credit is in effect borrowing from
its supplier. It saves cash today but will have to pay
later. This, of course, is an implicit loan from the
supplier.
We can calculate the implicit cost of this loan

Effective annual rate

(
= 1 + discount
)
discounted price
365 / extra days credit
- 1

40
 Terms of Sale
Example - On a $100 sale, with terms 5/10 net 60, what
is the implied interest rate on the credit given?

Effective annual rate

1+ discount
discounted price
365/extra days credit
-1
1 +
5 365/50
95 - 1 = .454, or 45.4%
41
 Credit Agreements
Terminology
open account
promissory note
commercial draft
sight draft
time draft
trade acceptance
bankers acceptance
irrevocable letter of credit
conditional sale
 Credit Analysis
Credit Analysis - Procedure to determine the likelihood
a customer will pay its bills.

Credit agencies, such as Dun & Bradstreet provide

reports on the credit worthiness of a potential
customer.
Financial ratios can be calculated to help determine a
customers ability to pay its bills.

43
 The Credit Decision
Credit Policy - Standards set to determine the amount
and nature of credit to extend to customers.
Credit Scoring What your lender wont tell tell you.

Extending credit gives you the probability of making

a profit, not the guarantee. There is still a chance of
default.
Denying credit guarantees neither profit or loss.

44
 The Credit Decision
Based on the probability of payoffs, the expected
profit can be expressed as:

p x PV(Rev - Cost) - (1 - p) x (PV(cost)

The break even probability of collection is:

PV(Cost)
p =
PV(Rev)
45
 The Credit Decision
The credit decision and its probable payoffs

Payoff = Rev - Cost

Customer pays = p

Offer credit

Customer defaults = 1-p

Payoff = - Cost

Refuse credit
Payoff = 0
46
 Collection Policy
Collection Policy - Procedures to collect and monitor
receivables.

Aging Schedule - Classification of accounts receivable

by time outstanding.

Factoring Arrangement whereby a financial institution

buys a company's accounts receivable and collects
the debt.

47
 Collection Policy
Sample aging schedule for accounts receivable

Customer' s Less than More than

1 - 2 months 2 - 3 months Total Owed
Name 1 month 3 months
A 10,000 0 0 0 10,000
B 8,000 3,000 0 0 11,000
* * * * * *
* * * * * *
* * * * * *
Z 5,000 4,000 6,000 15,000 30,000
Total $200,000 $40,000 $15,000 $43,000 $298,000

48
 Cash

Cash does not pay interest

Move money from cash accounts into short
term securities
Sweep programs
Concentration banking
Lock-box system
 Cash
How purchases are paid. Percentage of total by payment type for 2007.

100%
Direct debits
Credit transfers
80% Credit/debit cards
Checks
60%

40%

20%

0%
Sweden
Germany
Canada

France

Italy

Netherlands

USA
UK
Switzerland
 Cash
Electronic Funds Transfer (EFT)
Automated Clearinghouse (ACH)
International cash management
Compensating balances

51
 Marketable Securities
Microsoft 2008 cash investments

Investment Amount
Money market mutual funds $1,044 million
Commercial paper 787
Certificates of deposit 1,580
US Govt and agency securities 4,200
Foreign govt bonds 3,466
Mortgage backed securities 3,628
Corporate notes and bonds 5,013
Municipal securities 761
Other 520
Total 20,999

52
 Money Market Investments

MATURITIES Basis for

Investment Borrower When Issued Marketability Calculating Interest Comments
4 weeks, 3 Excellent
months, or 6 secondary
Treasury bills U.S. government months market Discount Auctioned weekly
Benchmark bills by
Federal agency FHLB, "Fannie Mae," Very good regular auction;
benchmark bills and Sallie Mae," Freddie Overnight to 360 secondary discount notes sold
discount notes Mac," etc. days market Discount through dealers

Tax-anticipation notes
(TANs), revenue
anticipation notes
Municipalities, Good Usually interest- (RANs), bond
Tax-exempt states, school 3 months to 1 secondary bearing with interest anticipation notes
municipal notes districts, etc. year market at maturity (BANs), etc.
Tax-exempt variable- Municipalities, Good Long-term bonds with
rate demand notes states, universities, secondary put options to demand
(VRDNs) etc. 10-40 years market Variable interest rate repayment

53
 Money Market Investments
MATURITIES Basis for
Investment Borrower When Issued Marketability Calculating Interest Comments
Non-negotiable time
deposits and Usually 1 to 3
negotiable months; also Fair secondary
certificates of Commercial banks, longer-maturity market for Interest-bearing with
deposit (CDs) savings and loans variable-rate CDs negotiable CDs interest at maturity Receipt for time deposit
Industrial firms,
finance companies, Maximum 270 Dealers or Unsecured promissory
and bank holding days; usually issuer will note; may be placed
Commercial paper companies; also less than 10 repurchase through dealer or
(CP) municipalities years paper Usually discount directly with investor
Largely finance Minimum 270
companies and days;usually Dealers will Unsecured promissory
Medium-term notes banks; also industrial less than 10 repurchase Interest-bearing; note placed through
(MTNs) firms years notes usually fixed rate dealer
Demand to pay that has
Bankers' Major commercial Fair secondary been accepted by a
acceptances (Bas) banks 1-6 months market Discount bank

Overnight to Repurchase price set

about 3 months; higher than selling Sales of government
Dealers in U.S. also open repos price; difference securities by dealer with
Repurchase government (continuing No secondary quoted as repo simultaneous agreement
agreements (repos) securities contracts) market interest rate to repurchase.

54
Sources of Short Term Borrowing
Bank loan (features)
Commitment
Maturity
Rate of interest
Syndicated loans
Loan sales and CDOs
Secured loans
Commercial paper
Medium term notes
55