INTRODUCTION TO SHORT-TERM FINANCIAL

MANAGEMENT
FIN 4707 || MAA
INTRODUCTION

 Short-term financial management refers to the utilization of the firm’s

current assets and liabilities to maximize shareholder wealth
INTRODUCTION

 The current accounts most pertinent to short-term financial management

include (also knows as Working Capital)
 ST financial assets
Expansion of
 cash and equivalents, the WC asset
accounts
absorb
 ST operating assets resources

 accounts receivable,
 inventory, Expansion of
WC liability
 ST operating liabilities accounts
provide
resources
 accounts payable(“free/spontaneous” financing)
 accruals.
OBJECTIVES

 Minimize short-term operating assets.

 However, it is important to note that there are trade-offs associated with
minimizing short-term operating assets.
 Optimize the dollar investment in these accounts to maximize firm value.
CASH AND SHORT-TERM INVESTMENTS
Working Capital Cycle concludes with collection of cash
 Liquid reserves
 Distributions to shareholders
 New investment
 Amortization of debt
Rationale for liquid reserves include:
 Funding daily operations
 Buffering against adverse conditions
 Attracting new shareholders by serving as a marketing tool
 Funding strategic acquisitions
MANAGING INVENTORY

 Trade-offs between:

 stock out costs

 cost of excess inventory

 ordering costs

 Just-In-Time
MANAGING RECEIVABLES

 Who should receive credit and how much?

 5 C’s of Credit
 Character
 Capacity to Pay
 Collateral
 Condition
 Capital
MANAGING RECEIVABLES

 Credit terms: n/30 or 2/10, n/30

 Monitoring the outstanding balance

 Speeding up the receipt of payments

 Reducing collection float
 Collection float – delay in collecting payment on behalf of the seller
MANAGING PAYABLES

 Considered as interest-free-financing

 Search for terms that match with cash receipts

 Timing of payment

 Controlled disbursement
LIQUIDITY

 Ability to pay its financial obligations when due, despite current economic conditions,
and to strategically pursue capital investments
 Efficient and effective use of WC allows improve firm liquidity, which in turn
maximizes shareholders wealth.
LIQUIDITY

 Important points
 Firm liquidity is different from asset liquidity.
 Liquidity and solvency are not identical

 firm liquidity also impacts long-term financial decisions.

 reduced firm liquidity (i.c., illiquidity) may result in reduced dividends to shareholders, a higher cost
of capital, and reduced capital investment. For various
 Key metric to measure liquidity is CCC
CASH CONVERSION CYCLE (CCC) – GRAPHICAL REPRESENTATION
 CCC- number of days that it typically takes to move funds from inventory to
receivables and from receivables to cash, after accounting for the payables period

 The cash conversion cycle is the net result of this sequence of cash inflows and
outflows
 Q – Shorter or longer CCC?
FIRM VALUE, LIQUIDITY & CCC

 Not only does the cash conversion cycle impact firm value from a liquidity
perspective, but it also impacts firm value through the time value of money.
 A general model for calculating the present value of a future short-term cash flow
(using the simple-interest method)
FIRM VALUE, LIQUIDITY & CCC

 Problem - suppose that your firm just made a credit sale of $100,000 that is payable
within 30 days. Assuming that the customer fulfills their obligation on day 30 and that
the discount rate is10%, what is the present value of this short-term cash flow? What
if the receivable was collected in 20 days?
 Points to note
 Strategies that speed up the collection results in higher present value
 This approach can also be applied to cash outflows
ILLIQUIDITY & PROFITABILITY

 Managing current assets and liabilities that spontaneously arise from daily operations
is critical.
 Without active management, the composition of these accounts may impair liquidity, even for
profitable firms.
 Case
 Consider the financial circumstances of the recently incorporated and privately held KB, Inc.
Initially, the owners contributed $500 of equity and borrowed $500 from a bank, as shown on the
following balance sheet.
...IN THE BEGINNING

Balance Sheet - June 1

Cash $1,000 Debt $ 500

Equity $ 500

Total $1,000 Total $1,000

THE NEXT DAY, JUNE 2

The company purchases

Fixed Assets (for $600 cash)

And Inventory (for $300 on account)

THE NEXT DAY, JUNE 2

Balance Sheet - June 2

Purchase Fixed Assets and Inventory

Cash $ 400
A/P $ 300
Inventory 300 Debt 500
Fixed Assets 600 Equity 500

Total $1,300 Total $1,300

END OF JUNE

The company
Sells its inventory for $700 on account

Incurs unpaid operating expenses of $200

Paid interest and taxes worth $75

Accumulates $100 of depreciation on its fixed

Assets

Generates profits of $25

END OF JUNE

Balance Sheet - June 30

Sale of product, incur operating expenses,
incur depreciation, and generate profit

Cash $ 325 A/P $ 300

A/R 700 Accruals 200
Inventory 0 Debt 500
Fixed Assets 600 Equity 500
(Accu. Dep.) (100) RE 25
Total $1,525 Total $1,525
JULY 1

Balance Sheet - July 1

Pay operating accruals with cash

Cash $ 125 A/P $ 300

A/R 700 Accruals 0
Inventory 0 Debt 500
Fixed Assets 600 Common Stock 500
(Accum Depr) (100) Retained Earnings 25
Total $1,325 Total $1,325
JULY 15

Balance Sheet - July 15

Pay payables with cash

Cash $ ( 175) A/P $ 0

A/R 700 Accruals 0
Inventory 0 Debt 500
Fixed Assets 600 Common Stock 500
(Accum Depr) (100) Retained Earnings 25
Total $1,025 Total $1,025
JULY 31

Balance Sheet - July 31

Collect accounts receivable

Cash $ 525 A/P $ 0

A/R 0 Accruals 0
Inventory 0 Debt 500
Fixed Assets 600 Common Stock 500
(Accum Depr) (100) Retained Earnings 25
Total $1,025 Total $1,025
IS WORKING CAPITAL NEEDED?

 One view
 Optimal level is zero
 WC is an idle resource
 Provides little or no value
 How much in resources to commit?

- The optimal investment in working capital is debatable

SUMMARY

 Firm must operate at a profitable level.

 A profitable firm may still struggle financially.

 Working capital soaks up cash flow and may cause an

otherwise profitable firm to fail.

 A successful firm’s operation is managed from a

 Profit, Wealth and a
 Cash flow perspective.