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Short-term Financial Planning and Management.

This topic discusses the fundamentals of short-term …nancial management; the analysis of decisions involving cash ‡ows which occur within a year or less. These decisions a¤ect current assets and /or current liabilities. We know that net working capital is the di¤erence between current assets and current liabilities; since short-term …nance is concerned with current assets and current liabilities, this topic is also referred to as working capital management. Some examples of short-term …nancial decisions are questions such as: 1) How much inventory should be kept on hand 2) How much cash should be kept on hand 3) Should goods be sold on credit 4) How should the …rm borrow short-term

A) Cash and net working capital Current assets are de…ned as cash and other assets that are expected to be converted to cash within one year. The four ma jor categories of current assets are: 1) cash 2) marketable securities 3) accounts receivable 4) inventory. Current liabilities are short-term obligations which require payment within one year. The three major categories are: 1) accounts payable 2) accrued wages and taxes, and other expenses payable 3) notes payable.

De…ning cash in terms of other elements The balance sheet identity can be written as: Current assets + Fixed assets = Current liabilities + Long-term debt + Equity Alternatively, by rearranging terms, this identity can be written: (Cash + Other current assets) - Current liabilities + Fixed assets = Long-term debt + Equity Solving this equation for Cash:


...........What choice of production technology 4.. Manufacturing the product. Buying raw materials.................................................How to collect cash....... Uses of cash are just the reverse.... Sources of cash always involve increasing a liability or equity account and/ or decreasing an asset account.. Paying cash for purchases........How much inventory to order 2.................. Cash in‡ows are unsynchronized because in‡ows from the sale of a product do not occur at the same time as 2 .Fixed assets... These activities create cash in‡ows and out‡ows that are both unsynchronized and uncertain................. Selling the product... A use of cash involves increasing an asset account or decreasing a liability (equity) account............... those decrease cash are called uses of cash.To borrow............ Collecting cash ...............Current assets (excluding cash) ..................Decisions 1...................................... This equation clearly indicates those actions which increase cash and those which decrease cash: Activities which increase cash: 1) Increase long-term debt (borrowing long-term) 2) Increase equity (sell common stock) 3) Increase current liabilities (borrow short-term) 4) Decrease current assets other than cash (sell inventory for cash) 5) Decrease …xed assets (sell …xed assets) Activities which decrease cash: 1) Decrease long-term debt (repay long-term debt) 2) Decrease equity (repurchase common sto ck) 3) Decrease current liabilities (repay short-term debt) 4) Increase current assets other than cash (buy inventory for cash) 5) Increase …xed assets (buy …xed assets) Activities that increase cash are called sources of cash.....Cash = Long-term debt + Equity + Current liabilities .......To o¤er cash terms or credit terms to customers 5.......... a) The Operating Cycle and the Cash Cycle A typical manufacturing …rm’s short-run operating and …nancing activities might consist of the following events: Events... or draw down cash balance 3...

.... Drysdale & Co... represents balance sheet data for the beginning and end of 1995.. and income statement data for the year 1995: Balance Sheet Item Inventory Accounts Receivable Accounts Payable Begining $4.... which can be provided either by borrowing or by maintaining a liquid reserve of marketable securities.$13.. The accounts payable period is the length of time the …rm can delay payment on its purchases....... The accounts receivable period is the time required to collect cash from a sale.... and sell a product.500 3..500 2.. produce.. This line consists of an operating cycle and a cash cycle.......000 Cost of Goods Sold... This mismatch suggests the need for short-term …nancing.....500 2. Alternatively. Example: The following information for D.$18.. c) Calculating the Operating and Cash Cycles The operating and cash cycle can be calculated from balance sheet and income statement information using …nancing ratios. b) De…ning the Operating and Cash Cycles Short-term operating activities and cash ‡ows can be represented by a cash-‡ow line... Inc...000 2..750 4...000 4..... A cash cycle of 30 days means that in‡ows occur 30 days after out‡ows. The length of the operating cycle is equal to the sum of the inventory period and the accounts receivable period..250 Ending $5.. The inventory period is the time required to order. the cash cycle can be shortened by changing the inventory. accounts receivable or accounts payable period.. The uncertainty of cash ‡ows arises from the fact that future sales and costs can not be predicted with certainty.... The cash cycle is the di¤erence between the operating cycle and the accounts payable period ...300 3 .Annual Net Sales (all credit)....500 Average $4.375 Income Statement Item..out‡ows to acquire raw materials.

000 = 4. we compute these from the inventory turnover ratio and the receivable turnover ratio. respectively. and grants liberal credit terms which result in relatively high levels of accounts receivable.6 = 65.36 days Assuming that all sales are credit sales. In 4 . while a restrictive policy implies a relatively low ratio. These calculations indicate that. The operating cycle is equal to the inventory period plus the accounts receivable period. and the …nancing of current assets.Calculate the operating cycle and the cash cycle for Drysdale & Co.60 times Payables period = 365/Payables turnover = 365/5.18 days = 146.80 times inventory is “turned over” 2. Therefore.47 days = 211 days In order to determine the cash cycle.80 times per year.375 = 5. a restrictive …nancing policy requires that current assets are …nanced primarily by short-term debt. A ‡exible current asset policy requires maintaining a relatively high ratio of current assets to sales.47 . Restrictive policies mean that the …rm maintains relatively low levels of current assets. then: Receivables turnover = Credit Sales/Average receivables = $18. the time between Drysdale’s acquisition of inventory and collection of payment on sales is approximately 211 days.300/$2.11 days The operating cycle is: Operating cycle = Inventory period + Accounts Receivables period = 130.000/$4. The size of the …rm’s investment in current assets A ‡exible current asset policy implies that the …rm maintains relatively high levels of cash.36 days + 81.Accounts payable period = 211.80 = 130.5 = 81.65.29 days = 146 days. Inventory turnover = Cost of goods sold/Average inventory = $13. we …rst compute the accounts payable turnover and then the accounts payable period: Payable turnover = Cost of goods sold /Average payables = $13. the cash cycle is: Cash cycle = Operating cycle .300/$4. marketable securities and inventories. on average.18 days Therefore.50 times Receivables period = 365/Receivables turnover = 365/4.11 days = 211. B) Some aspects of short-term …nancial policy A …rm’s short-term …nancial policy has two dimensions: the size of the investment in current assets. and the time between Drysdale’s payment for acquisitions and collection of payment on sales is approximately 146 days. the inventory period is determined as follows: Inventory period = 365/inventory turnover = 365/2. A ‡exible …nancing policy employs relatively less short-term debt and more long-term debt.750 = 2.

investment in inventory implies an opportunity cost for the …rm. thereby increasing discounts taken on accounts payable and reducing borrowing costs required in order to meet expenditures. or order costs. The following …gures demonstrates how combined costs reach a minimum at CA¤ The optimal investment in current assets is the level that minimizes the sum of the carrying costs and the shortage costs. should be higher for a ‡exible policy. and shortage costs which decrease with increases in current assets.order to determine the optimal levels of current assets. A ‡exible policy requires greater initial cash out‡ows in order to purchase inventory. Carrying costs are the opportunity costs of investment in current assets. customer goodwill. …nance credit sales. Trading or order costs arise when the …rm runs out of cash or inventory and must consequently incur the cost of restocking. In addition. liberal credit policies also stimulate sales. and costs related to safety reserves. The two kinds of shortage costs are trading costs. and maintain high levels of cash and marketable securities. 5 . For example. The costs associated with managing currents assets can be classi…ed as follows: Carrying costs are costs that increase with increases in current assets. the costs and bene…ts associated with each policy must be identi…ed. Costs related to safety reserves include loss of sales. it forgoes the opportunity to earn interest on the investment of that cash. Similarly. or production time when a stock out (or cash out ) occurs. the larger cash balances associated with a ‡exible policy ensure that bills can be paid promptly. Future cash in‡ows. Similarly. if the …rm holds idle cash. however.

sales made during the …rst (90 . Wages. and. taxes. 3 $300 Qtr. while sales during the remaining 54 days will be collected during the following quarter. Erskine maintains a $10 minimum cash balance to guard against foreseen contingencies and forecasting errors.54) = 36 days of the quarter will be collected before the end of the quarter. 2 $200 Qtr. In the most recent quarter. In the …rst quarter. Erskine & Company has estimated sales for the next four quarters as follows: Qtr. cash collections would be the beginning receivables of $100 plus 40% of sales. taxes. Example: C. A capital expenditure of $100 is planned in the second quarter. Therefore. or: Cash collections = Beginning accounts receivables + (40%£ Sales) = $100 + (0. We illustrate the preparation of a cash budget with the following example. (4) long-term …nancing payments. (2) wages. 1 Sales $150 Qtr. Erskine & Co. the cash budget is the primary tool of short-run planning. Erskine’s purchases are (0. Cash out‡ows consist of: (1) payments to suppliers. a) Sales and Cash Collections We begin by computing the cash collections for Erskine for each quarter. Erskine’s payments to suppliers are equal to the previous period’s purchases. Prepare a cash budget for C. Interest and dividends are $20 per quarter. (3) capital expenditures. Erskine’s purchases from suppliers during a quarter are equal to 50% of next quarter’s forecast sales. that is. ending receivables for a given quarter are 60% of sales during that quarter. The 54-day collection period implies that [(90 ¡ 54) =90] = 40% of the sales in a given quarter will be collected during the current quarter and (54/90)=60% during the following quarter. and other expenses.4 £$150) = $100 + $60 = $160 : Erskine’s cash collections are thus: 6 . 4 $250 Accounts receivable at the beginning of the year are $100. which will be paid during the …rst quarter. Erskine has a 54-day collection period. and other expenses are 30% of sales.50 £$150) = $75 .The Cash Budget The Cash budget is a forecast of estimated cash in‡ows and out‡ows over a period of time.

2 $30 -120 -90 10 -$100 Qtr. taxes. 4 $180 250 280 150 The cash out‡ows for Erskine are: Qtr.Qtr. 4 -$110 60 -50 10 -$60 7 . 1 Payment of Accounts Wages. 1 Begining cash balances + Net cash in‡ow Ending cash balances .Minimum cash balance Cumulative surplus (de…cit) $10 20 $30 10 $20 Qtr. 4 $125 75 0 20 $220 $75 45 0 20 $140 Include interest and dividends b) The Cash Balance The forecast net cash in‡ow is the di¤erence between cash collections and cash out‡ows. for Erskine at the end of each quarter: Qtr. or de…cit. 4 $280 220 60 Erskine maintains a $10 minimum cash balance. 2 $160 280 -120 Qtr. and other expenses Capital Expenditures Long-term …nancing expenses¤ Total ¤ Qtr. 3 $150 90 0 20 $260 Qtr. we now compute the cumulative surplus.Total cash disbursements Net Cash in‡ow $160 140 20 Qtr. 1 Total cash collections . 1 Beginning Receivables Sales Cash Collections Ending Receivables $100 150 160 40 Qtr. 3 -$90 -20 -110 10 -$120 Qtr. 3 $240 260 -20 Qtr. 2 $100 60 100 20 $280 Qtr. The net cash in‡ow is determined as follows: Qtr. Assuming that Erskine maintains this $10 balance at the beginning of the …rst quarter. 2 $40 200 160 120 Qtr. 3 $120 300 240 180 Qtr.

ending receivables for a particular quarter would be the other half of sales. Another example of the Cash Budget The cash budget is a primary tool in short-run …nancial planning. It records estimates of cash receipts (cash in) and disbursements (cash out). so total cash collections are: Cash collections = Beginning accounts receivables + (1/2 £Sales) For example. 1/2 £$200 = $100. 2 $100 300 250 150 Qtr. The result is an estimate of the cash surplus or de…cit. Based on the sales forecasts. This happens because sales made during the …rst 45 days of a quarter are collected that quarter. It occurs because of the seasonal pattern of sales. First. and the planned capital expenditure. ABC has a 45-day receivables or average collection period. This would be the beginning receivables in the second quarter. the cash budget helps the manager explore the need for short-term borrowing. First-quarter sales are projected at $200. 4 $125 400 325 200 Cash Out‡ows 8 . Cash collections in the second quarter are thus $100 plus half of the pro jected $300 in sales. 3 $150 250 275 125 Qtr. so ending receivables are $100. the delay in collections. any sales made in the …rst half of the quarter are collected. Since beginning receivables are all collected along with half of sales. Continuing this process. for a total of $220. we need to estimate the ABC’s cash collections. 2 $300 Qtr. Erskine has a cash shortfall. 4 $400 ABC also started the year with accounts receivables equal to $120. we can summarize ABC’s projected cash collections. Importantly. or $250 in total. Sales made in the second 45 days are collected in the next quarter.Beginning in the second quarter. This means half of the sales in a given quarter are collected the following quarter. in the …rst quarter. We take the following example: Example: ABC Company has estimated sales for the next four quarters as follows: Qtr. 1 Sales $200 Qtr. 1 Beginning Receivables Sales Cash Collections Ending Receivables $120 200 220 100 Qtr. so all of them are collected sometime during the quarter. It allows the …nancial manager to identify short-term …nancial needs and opportunities. Qtr. Second. cash collections would be the beginning receivables of $120 plus half of sales. any receivables that we have at the beginning of a quarter would be collected within 45 days. 3 $250 Qtr.

a $10 is reserved as a minimum. 9 . ² Capital expenditures: these are payments for cash for long-lived assets. these payments are made sometimes after purchases. taxes. Furthermore. The net So there is a cash surplus in the …rst and third quarter. This increase by $40 during the quarter.Now. and other expenses Capital Expenditures Long-term …nancing expenses¤ Total cash in‡ow is determined as follows: Qtr. ABC plans a major plant expansion (a capital expenditure) of $100 in the second quarter. so we substract it out and …nd that the …rst-quarter surplus is $60 . and the ending balance is $60. consider the cash disbursements or payments. taxes. and other expenses are routinely 20 percent of sales. 4 $325 340 -15 $120 40 0 20 $180 Qtr. 2 $180 60 100 20 $360 Qtr.Total cash disbursements Net Cash in‡ow $220 180 40 Qtr. ² Wages. and other expenses. Of this.60 £$200 = $120 in suppliers. ABC maintains a $10 minimum cash balance to guard against unforeseen contingencies and forecasting errors. We assume that ABC starts the year with a $20 cash balance.$10 = $50. This would actually be paid in the …rst quarter of the coming year. ABC’s payments to suppliers are equal to the previous quarter’s purchases. and a cash de…cit in the second and fourth. Generally. 1 Payment of Accounts Wages. 1 Total cash collections . taxes. In addition. in the quarter just ended. So we start the …rst quarter with $20 in cash. 3 $275 220 55 Qtr. Wages. 3 $150 50 0 20 $220 Qtr. ² Long-term …nancing expenses: it includes for example: interest payments on long-term outstanding debt and dividend payments to shareholders. 2 $250 360 -110 Qtr. 4 $240 80 0 20 $340 The forecast net cash in‡ow is the di¤erence between cash collections and cash out‡ows. ABC’s purchases from suppliers (in dollars) in a quarter are equal to 60 percent of next quarter’s predicted sales. interest and dividends are currently $20 per quarter. we get the cash disbursements: Qtr. If we put all these together. For example. These comes in the following forms: ² Payments of accounts payables. so the accounts payable period is 90 days. ABC ordered 0.

$20 40 $60 -10 $50 Qtr. 3 -$50 55 5 -10 -$5 Qtr. We need another $10 as a bu¤er.ABC starts the second quarter with $60 in cash (the ending balance from the previous quarter). Interest in the last quarter is thus $8 £0 :05 = $0:4 million. In addition. We have to borrow this amount. so the ending balance is $60 . ABC A short-Term Financial Plan We assume that ABC manages to borrow any needed funds on a short-term basis. but.Minimum cash balance Cumulative surplus (de…cit) still has a $20 de…cit. Net cash in‡ow in the following quarter is $55 million. bringing out total borrowing up to $15. So. We know from the previous table that ABC has a second-quarter de…cit of $60 million.$110 = -$50. We still owe $60 . We assume that ABC starts the year with no short-term debt. The interest rate is 20 percent APR. 2 $60 -110 -50 -10 -$60 Qtr.4 + 8 = $23. 1 Begining cash balances + Net cash in‡ow Ending cash balances .52 = $8 million at the end of the third quarter. The calculations are summarized below: Qtr. We now have to pay $60 £0 :05 = $3 million in interest out of that. net in‡ows in the last quarter are -$15 million. 4 $5 -15 -10 -10 -$20 The situation is pro jected to improve to a $5 de…cit in the third quarter. so we have to borrow $15. leaving $52 million to reduce the borrowing. There is a net cash in‡ow of $-110.4 million. the rate is 20%/4 = 5% per quarter.4 million. by the year’s end. and it is compounded on a quarterly basis. so the total de…cit is $-60. The following table extends the previous one to include these calculations: 10 .

for a total of $23. the …rm’s short-term needs costs more than $3 million on interest (before taxes) for the year. 3 $10 55 – -3 -$52 10 -10 0 60 -52 8 Qtr. It is time to start lining up the sources of funds.4.4 — 10. ABC would need to borrow $60 million or so on a shortterm basis. 4 $10. the $20 million plus de…cit would probably also keep growing. 1 Begining cash balances Net cash in‡ow Net short-term borrowing Interest on short–term borrowing Short-term borrowing repaid Ending cash balance Minimum cash balance Cumulative surplus (de…cit) Beginning short-term borrowing Change in short-term debt Ending short-term debt $20 40 — — — $60 -$10 $50 0 0 0 Qtr.4 -0. and the need for additional …nancing is permanent. Also.4 23. This is a starting point for the ABC to being evaluating alternatives to reduce this expense. ABC may wish to think about raising money on a long-term basis to cover this need.4 = $3. $20. if ABC’s sales are expected to keep growing. For example. shortterm credit is expensive. 2 $60 -110 60 — — 10 -10 0 0 60 60 Qtr. Also. The plan illustrates that in about 90 days.0 -15.0 15. can the $100 million planned expenditure be postponed or spread out. $3 + 0. 11 .4.0 8.0 15. plus the interest paid during the year.0 0. At 5 percent per quarter.0 -10.Qtr.4 Notice that the ending short-term debt is just equal to the cumulative de…cit for the entire year.

the terms of sale.Credit And Inventory Management Chapter 19 Credit policy is analyzed by computing the NPV of a credit decision. The …rm’s terms of sale consist of the following aspects of a credit sale: the credit period. and collection policy. or it may decide to extend credit to its customers. credit analysis. A …rm’s collection policy is the set of procedures the …rm uses to collect payment on accounts. 3) The cost of debt: The cost of …nancing receivables must be considered in analyzing credit policy. Evaluating a proposed credit policy The relevant variables in analyzing credit policy are: P = Price per unit v = Variable cost per unit Q = Current quantity sold per month Q. 4) The probability of nonpayment: Some buyers will default. = Quantity sold under new policy R = Monthly required return Example: Suppose that a …rm is considering granting credit terms of net 30 days. In this chapter. A) Analyzing Credit Policy Credit policy e¤ects: The decision regarding whether to grand credit depends on the following: 1) Revenue e¤ects: Granting credit results in both a delay in revenue collections and an increase in total revenue. Consider the following information regarding the decision: 12 . 2) Cost e¤ects: Granting credit results in increased costs directly associated with the credit process and. If credit is extended. then the …rm must establish a credit policy. Credit analysis is the process of attempting to distinguish between customers who are likely and not likely to make payment on an account. the cash discount and discount period. which involves three distinct components. and the type of credit instrument. A …rm may require cash on or before delivery in payment for its products. leaving the other topics out. 5) The cash discount: Some customers will pay during the discount period to take advantage of the discount. if sales increase. increased variable costs. we discuss only the credit policy.

$5) £ 120= $720 The incremental cash ‡ow is de…ned as follows: Incremental cash ‡ow = Cash ‡ow (new policy ) . = 120 R = 1% Should the …rm grant the credit terms of net 30 days to its customers. ¡ Q ) = $1100 + $100 = $1200 The net present value of the change in credit policy is: NPV = -[P Q + v (Q.$5) £ (20) = $120 This incremental cash ‡ow is in the form of a monthly annuity so that the present value of the annuity is: PV = ((P ¡ v )(Q . Solution: If the …rm does not extend credit. ¡(P .v) £ Q .$5) £ 100 = $600 If credit is granted.v)(Q .¡ Q) = ($11 . The cost of the change in credit policy is the sum of two components. the change in credit policy to terms of net 30 days is bene…cial in this example. ¡ Q)) =R = $120 =:01 = $12000 producing the additional units: v(Q .v) £ Q. ¡ Q )] + ((P ¡ v )(Q. ¡ Q) = $5 £ (120 ¡ 100) = $100 Second. then: Cash ‡ow (new policy) = (P . this cost is: PQ = $11£ 100 = $1100 The sum of these costs is: PQ + v( Q.P = $11 v = $5 Q = 100 Q. ¡ Q )) =R = ¡$1200 + $12000 = $10800 Therefore.v) £ Q = ($11 . First. the variable cost of B) Optimal Credit Policy 13 . = ($11 .Cash ‡ow (old policy ) = (P . Since collections are permanently delayed by thirty days. then the monthly sales are: P £ Q = ($11 £ 100) = $1100 and monthly variable costs are: v £ Q = ($5 £ 100) = $500 The cash ‡ow is: Cash ‡ow (old policy) = (P .v) £ Q = (P . the …rs month’s sales which would be collected under the old policy are not collected until thirty days later under the new policy.

The carrying costs include the required return on the investment in receivables. the …rm must consider two categories of costs: the carrying costs associated with granting credit and investing in accounts receivables. it is likely that …rms with (1) excess capacity. This is depicted in the …gure. 14 . The optimal amount of credit minimizes the sum of the carrying costs plus the opportunity costs which is the total credit cost curve. and the opportunity costs which result from a refusal to grant credit. The opportunity costs are the foregone pro…ts from the lost sales if the …rm denies credit. (2) low operating costs. In performing this analysis. all other things being equal. and (3) repeat customers will extend credit more liberally than otherwise. In general.Firms must also consider the optimal amount of credit to be granted. and the costs of managing credit and credit collections. losses from bad debts.

and then determining the creditworthiness of the customer. we assumed that the …rm has no repeat business. with in…nite life ( a perpetuity). The probability that he will not default is (1 . should the …rm extend credit to the a new customer.25) = . The net present value is the cost minus the present value of the cash ‡ow: NPV = -v + ((1 ¡ ¼ ) £ P ) = (1 + r) 2 = ¡ $70 + $75 =(1 :01) = $3:52 Since the present value is positive. Assume that this is a one-time sale. The variable cost is $70 per unit and the monthly required return is r = 1%. 15 . Assuming that a customer who does not default will purchase one unit every other month forever. since it is considered as an annuity.¼ ) £ (P ¡ v ) = :75 £ $30 = $22:50 The net present value of the decision to grant credit is: NPV = -v + ((1 ¡ ¼ ) £ ( P ¡ v )) =r = ¡ $70 + $22 :50 =:02 = $1:055 Since the net present value is positive. Example: Assume the following data from the previous example: P = $100 per unit . In the next example. we analyze the credit decision under the following assumption about repeat business: a new customer who does not default on his …rst purchase will remain a customer inde…nitely and will never default. the …rm’s required return for a two-month period is 2%. In two months. and then deciding whether to extend credit to that customer. Notice.. v = $70. it is bene…cial for the …rm to extend credit to the new customer. In the preceding example. Solution: the cost to the …rm is the variable costs v = $70. The probability of default is ¼ = 25%: Should the …rm grant credit to the new customer. and ¼ = 25%: Also. Consider a customer who purchases one unit on credit at a price of P = $100 per unit. we are discounting by r.C) Further on Credit Analysis Credit analysis is the process of estimating the probability that a customer will not pay.75 and the expected net cash in‡ow in two months is: ( 1 . the customer will either default or he will pay p = $100 and purchase another unit. the …rm should extend credit to the customer. The …rm must …rst gather relevant information.

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