Chapter 18

Short-Term Finance
and Planning
McGraw-Hill/Irwin
Copyright © 2012 by McGraw-Hill Education (Asia). All rights reserved.
Learning Objectives
• To provide the definition and concept of the working capital
management.
• To discuss components and importance of working capital.
• To explain the risk and return trade-off from the working
capital management perspective.
• To discuss the strategies in working capital management.
• To discuss the cash conversion cycle.
• To develop a cash budget.
• To discuss types of the short-term financing.
• To calculate the cost of short-term financing with insertion
of compensation balance, discounted interest rate, and
other related features.
18-1
Sources and Uses of Cash
• Balance sheet identity (rearranged)
– NWC + fixed assets = long-term debt + equity
– NWC = cash + other CA – CL
– Cash = long-term debt + equity + CL – CA 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
18-2
The Operating Cycle
• Operating cycle – time between purchasing the inventory
and collecting the cash from sale of the inventory
• Inventory period – time required to purchase and sell the
inventory
• Accounts receivable period – time required to collect on
credit sales
• Operating cycle = inventory period + accounts receivable
period
18-3
The Cash Cycle
• Cash cycle
– Amount of time we finance our inventory
– Difference between when we receive cash from the sale and
when we have to pay for the inventory
• Accounts payable period – time between purchase of
inventory and payment for the inventory
• Cash cycle = Operating cycle – accounts payable
period
18-4
Figure 18.1
18-5
Example Information
• Inventory:
– Beginning = 200,000
– Ending = 300,000
• Accounts Receivable:
– Beginning = 160,000
– Ending = 200,000
• Accounts Payable:
– Beginning = 75,000
– Ending = 100,000
• Net sales = 1,150,000
• Cost of Goods sold = 820,000
18-6
• Inventory period
– Average inventory = (200,000+300,000)/2 = 250,000
– Inventory turnover = COGS / (Ave inventory) =820,000/250,000 = 3.28
times
– Inventory period = 365 / 3.28 = 111 days
• Inventory turnover: A ratio showing how many times a company’s
inventory is sold and replaced over a period.
• Inventory period: The days required to sell the average inventory on hand.
• Receivables period
– Average receivables = (160,000+200,000)/2 = 180,000
– Receivables turnover = Net Sales / (Ave receivables) =1,150,000 /
180,000 = 6.39 times
– Receivables period = 365 / 6.39 = 57 days
• Operating cycle = 111 + 57 = 168 days
• Receivables turnover: A ratio showing how many times a company
collects on its receivables over a period. A high ratio implies more efficient
collection of debt.
• Receivables period: The days required to collect the average accounts
receivables.


18-7
Example: Cash Cycle
• Payables Period
– Average payables = (75,000+100,000)/2 = 87,500
– Payables turnover = COGS / (Ave payables) = 820,000 /
87,500 = 9.37 times
– Payables period = 365 / 9.37 = 39 days
• Cash Cycle = operating cycle – payables period =168 – 39 =
129 days
• We have to finance our inventory for 129 days
• If we want to reduce our financing needs, we need to
look carefully at our receivables and inventory periods
– they both seem extensive. A comparison to industry
averages would help solidify this assertion.
18-8
Short-Term Financial Policy
• Size of investments in current assets
– Flexible (conservative) policy – maintain a high ratio of current
assets to sales
– Restrictive (aggressive) policy – maintain a low ratio of current
assets to sales
• Financing of current assets
– Flexible (conservative) policy – less short-term debt and more
long-term debt
– Restrictive (aggressive) policy – more short-term debt and less
long-term debt
18-9
Carrying vs. Shortage Costs
• Managing short-term assets involves a trade-off
between carrying costs and shortage costs
– Carrying costs – increase with increased levels of
current assets, the costs to store and finance the
assets
– Shortage costs – decrease with increased levels of
current assets
• Trading or order costs
• Costs related to safety reserves, i.e., lost sales and
customers, and production stoppages
18-10
Temporary vs. Permanent Assets
• Temporary current assets
– Sales may be seasonal
– Additional current assets are needed 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 aren’t sold
18-11
Choosing the Best Policy
• Cash reserves
– High cash reserves mean that firms will be less likely to experience
financial distress and are better able to handle emergencies or take
advantage of unexpected opportunities
– 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
• Interest Rates
– Short-term rates are normally lower than long-term 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 the firm
18-12
Cash Budget
• 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 requirements
• Allows a company to plan ahead and begin the search for
financing before the money is actually needed
18-13
Cash Budget
14
Exercise 1
As a cash manager, you are required to prepare a cash budget for May to
August 2013. The sales in March and April were RM62,000 and
RM50,000, respectively. The operation manager projected that 30% of
Nanny Nugget’s sales are collected one month after the sale and the
balance two month after the sales. The estimated sales for May
through August 2013 are given below.

Month May June July August
Projected Sales(RM) 60,000 80,000 85,000 70,000
Projected Purchases (RM) 48,000 51,000 42,000 40,000

The purchase in April was RM36,000. These purchases are paid in the
following month.

15
• Wages and salaries, rent and other expenses are as follows (RM):
May June July August
Wages and salaries 4,000 5,000 6,000 4,000
Rent 3,000 3,000 3,000 3,000
Other expenses 1,000 500 1,200 1,500
Depreciation 500 500 500 500

• Nanny Nugget needs to pay RM4,000 interest on long-term debt in May
2013.
• Principal amount of short-term debt amounting RM8,000, and its
interest amounting RM200 will be due in July 2013.
• A tax payment will also be due in July amounting RM5,200.
• Nanny needs to purchase equipment costing RM10,000 in May 2013.

Cash Budget
16
• The ending cash balance in April was RM10,000 and will
continue to maintain the minimum cash balance in the near
future.
• Additional borrowing is allowed to maintain the minimum
cash balance. Interest on short-term fund is 12% p.a. or 1%
per month. Interest will be paid the following month after the
fund was borrowed.

Construct a cash budget for month May to August.
Cash Budget
17
Constructing a cash budget
• Salco company wants to prepare cash budget for upcoming 6 months.
• 30% of sales are collected 1 month after sales, 50% 2 months after
sale, and the reminder during the third month following the sales.
• Purchase equal 75% of sales and are made 2 months in advance of
anticipated sales. Payments are made in the month follwoing
purchases.
• Equipment purchased on February of $14,000 and the repayment of a
$12,000 loan in May. In June, Salco will pay interest of $7,500 on its
$150,000. interest of 12,000 short term repaid in May is $600.
• Salco has a cash balance of $20,000 and wants to maintain a minimum
balance of $10,000.
• Interest on the borrowed funds equals 12% per annum or 1% per month
and is paid in the month following the one in which funds are borrowed.

18
19
Short-Term Borrowing
• Unsecured Loans
– Line of credit
– Committed vs. noncommitted
– Revolving credit arrangement
– Letter of credit
• Secured Loans
– Accounts receivable financing
• Assigning
• Factoring
– Inventory loans
• Blanket inventory lien
• Trust receipt
• Field warehouse financing
• Commercial Paper
• Trade Credit
18-20
Example: Compensating Balance
1. We have a $500,000 line of credit with a 15% compensating
balance requirement. The quoted interest rate is 9%. We
need to borrow $150,000 for inventory for one year.
– 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%
2. With a quoted interest rate of 5% and a 10% compensating
balance, what is the effective rate of interest (use a $200,000
loan proceeds amount)?
Borrow $200,000 / (1 - 0.1) = $222,222 Pay interest of .05 x $222,222 = $11,111
Effective rate of interest = $11,111/$200,000 = .05555 = 5.56%
18-21
End of Chapter
18-22