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
• Summary and Conclusions

18-0
LO4
Sources and Uses of Cash 18.1

•Statement of Change in Financial Position

identity (rearranged)
• Net working capital + Fixed assets =
Long-term debt + Equity
• NWC = Cash + other CA – CL
• Cash = Long-term debt + Equity +
Current liabilities – Current assets other
than cash – Fixed assets

18-1
LO4 Sources and Uses of Cash - continued

• Sources
• Increasing long-term debt, equity or current
liabilities
• Decreasing fixed assets or current assets
other than cash
• Uses
• Decreasing long-term debt, equity or current
liabilities
• Increasing fixed assets or current assets other
than cash
18-2
LO1
The Operating Cycle 18.2
• Operating cycle – time between
purchasing the inventory and collecting the
cash from credit sales
• Inventory period – time required to
purchase and sell the inventory
• Accounts receivable period – time to
collect on credit sales
• Operating cycle = Inventory period +
Accounts receivable period
18-3
LO1
The Cash Cycle
• Cash cycle
• Time period for which we need to finance our
Inventory + Accounts receivables
• 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
LO1 Figure 18.1 – Cash Flow Time Line

18-5
LO1
Example Information
• Inventory:
• Beginning = $5,000
• Ending = $6,000

• Accounts receivable:
• Beginning = $4,000
• Ending = $5,000

• Accounts payable:
• Beginning = $2,200
• Ending = $3,500

• Net sales = $30,000 (assume all sales are on credit)

• Cost of goods sold = $12,000
18-6
LO1
Example – Operating Cycle

•Inventory period
• Average inventory = ($5,000 + $6,000)/2 = $5,500
• Inventory turnover = $12,000 / $5,500 = 2.18 times
• Inventory period = 365 / 2.18 = 167 days
•Receivables period
• Average receivables = ($4,000 + $5,000)/2 = $4,500
• Receivables turnover = $30,000/$4,500 = 6.67 times
• Receivables period = 365 / 6.67 = 55 days
•Operating cycle = 167 + 55 = 222 days

18-7
LO1
Example – Cash Cycle

•Payables period
• Average payables = ($2,200 + $3,500)/2 = $2,850
• Payables turnover = $12,000 / $2,850 = 4.21
• Payables period = 365 / 4.21 = 87 days
•Cash cycle = 222 – 87 = 135 days
•We finance our Inventory + AR for 135 days
•We need to be looking more carefully at our
receivables and our payables periods – they both
seem excessive

18-8
LO2
Short-Term Financial Policy 18.3
• Size of investments in current assets
• Flexible policy – maintain a HIGH ratio of
Current assets to Sales
• Restrictive policy – maintain a LOW ratio of
Current assets to Sales
• Financing of current assets
• Flexible policy – LESS Short-term debt and
MORE Long-term debt
• Restrictive policy – MORE Short-term debt
and LESS Long-term debt
18-9
LO2
Carrying vs. Shortage Costs

•Managing short-term assets involves a trade-off between

carrying costs and shortage costs
• Carrying costs – INCREASE with INCREASED level
of current assets, costs to store & finance assets
• Shortage costs – DECREASE with INCREASED
level of current assets, the costs to replenish assets
• Trading or order costs
• Costs related to insufficient safety reserves, i.e.,
lost sales, lost customers & production stoppages

18-10
LO2 Figure 18.2 – Carrying Costs and Storage Costs

18-11
LO2 Figure 18.2 – Carrying Costs and Storage Costs

18-12
LO2 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 are not sold
18-13
LO2
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
18-14
LO2 Choosing the Best Policy continued

• 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

18-15
LO2 Choosing the Best Policy continued
• Relative 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 your firm
18-16
LO2
Figure 18.6 – A Compromise Financing
Policy

18-17
LO3
The Cash Budget 18.4

•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
18-18
LO3
Example: Cash Budget
Information
• Pet Treats Inc. specializes in gourmet pet treats
and receives all income from sales

• Sales estimates (in millions)

• Q1 Q2 Q3 Q4 Q1 next year
$500 $600 $650 $800 $550

• Accounts receivable
• Beginning receivables = $250
• Average collection period = 30 days

18-19
LO3
Example: Cash Budget
Information
• Accounts payable
• Purchases = 50% of next quarter’s sales
• Beginning payables = $125
• Accounts payable period is 45 days
• Other expenses
• Wages, taxes and other expense are 25% of
sales
• Interest and dividend payments are $50
• A major capital expenditure of $325 is
expected in the second quarter
• The initial cash balance is $100 and the
company maintains a minimum balance of $50
18-20
LO3
Example: Cash Budget – Cash
Collections
• ACP = 30 days, this implies that 2/3 of sales are
collected in the quarter made and the remaining 1/3 are
collected the following quarter
• Beginning receivables of $250 will be collected in the
first quarter
• Q1 Cash Collections: $250 + (2/3) x $500 = $583
Q1 Q2 Q3 Q4
Beginning Receivables 250 167 200 217
Sales 500 600 650 800
Cash Collections 583 567 633 750
Ending Receivables 167 200 217 267
18-21
 Example: Cash Budget – Cash
LO3
Disbursements
• Payables period is 45 days, so half of the purchases
will be paid for each quarter and the remaining will be
paid the following quarter
• Beginning payables = $125
• Q1 Pmt. of accounts: $125 + .5 x (.5 x $600) = $275
Q1 Q2 Q3 Q4
Payment of accounts 275 313 362 338
Wages, taxes and other expenses 125 150 163 200
Capital expenditures 325
Interest and dividend payments 50 50 50 50
Total cash disbursements 450 838 575 588

18-22
 Payment of accounts:
Q1: 125 + .5(600)/2 = 275
Q2: 275 + .5(650)/2 = 438
Q3: 162 + .5(800)/2 = 362
Q4: 200 + .5(550)/2 = 338

18-23
LO3
Example: Cash Budget – Net Cash Flow and
Cash Balance

Q1 Q2 Q3 Q4
Total cash collections 583 567 633 750
Total cash disbursements 450 838 575 588
Net cash inflow 133 -271 58 162

Beginning Cash Balance 100 233 -38 20

Net cash inflow 133 -271 58 162

Ending cash balance 233 -38 20 182

Minimum cash balance -50 -50 -50 -50
Cumulative surplus (deficit) 183 -88 -30 132
18-24
LO3
Short-Term Financial Plan 18.5
Q1 Q2 Q3 Q4
Beginning cash balance 100 233 50 50
Net cash inflow 133 -271 58 162
New short-term borrowing 88
Interest on short-term borrowing 3 1
Short-term borrowing repaid 55 33
Ending cash balance 233 50 50 178
Minimum cash balance -50 50 -50 -50
Cumulative surplus (deficit) 183 0 0 128
Beginning short-term debt 0 0 88 33
Change in short-term debt 0 88 -55 -33
Ending short-term debt 0 88 33 0
18-25
LO5
Short-Term Borrowing 18.6
• Operating Loans (lines of credit)
• Committed vs. Non-Committed
• Letter of credit (international financing)
• Revocable or Irrevocable
• Accounts receivable financing
• Covenants
• Factoring
• Securitizing Receivables (finance subsidiary)
• Inventory Loans
• Trust receipts, Floor planning
• Trade Credit
• Money Market Financing
• Commercial paper, Bankers acceptances
18-26
LO5 Example: Compensating Balance
(Bank Act forbids banks requesting such a requirement)

• We have a $500,000 operating loan with a 15%

compensating balance requirement
• The quoted interest rate is 9%
• Need to borrow $150,000 for one year
• How much do we actually 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%
• NB. 9%/(1 - .15) = 10.59%

18-27
LO5
Example: Factoring
• Average accounts receivable are $2M
• Credit sales are $24 million
• Factor receivables at 2% discount
• What is the effective rate of interest?
• Receivables turnover = 24/2 = 12 times
• Ave. collection period = 365/12 = 30.4 days
• APR = (.02/.98) x 12 = .2449 or 24.49%
• EAR = (1+.02/.98)12 – 1 = .2743 or 27.43%

18-28
LO5
Example: Trade Credit
• Supplier offers terms of 2/10 net 30
• What is the effective rate of interest?
• Suppose invoice is for $100
• Can pay invoice on day 10 for $98
• It costs $2 to borrow the $98 for 20 days
• APR = ($2/$98) (365/20) = .3724 or 37.24%
• EAR = (1+$2/$98)365/20 – 1 = .4459 or 44.59%

18-29
LO5
Trade Credit Formula
 % discount  365 
APR    
 100%  % discount  credit period  discount period 

 2%  365 
APR      .3724 or 37.24%
 100%  2%  30  10 

365/  credit period  discount period 

  % discount 
EAR  1    1
  100%  % discount 

365/  30 10 
  2% 
EAR  1     1  .4459 or 44.59%
  100%  2%  

18-30
LO5
Trade Credit Formula

APR  EPR  N

APR  .02040816  18.25  .3724 or 37.24%

EAR  1  EPR 
N
1

EAR  1  .02040816 
18.25
 1  .4459 or 44.59%

18-31
 Quick Quiz
• How do you compute the operating cycle
and the cash cycle?
• What are the differences between a
flexible short-term financing policy and a
restrictive one? What are the pros and
cons of each?
• What are the key components of a cash
budget?
• What are the major forms of short-term
borrowing? 18-32
 Summary 18.7
• Short-term finance involves short-lived assets
and liabilities.
• Current assets and current liabilities arise in the
short-term operating activities and the cash cycle
of the firm
• Managing short-term cash flows finding the
optimal trade-off between carrying costs and
shortage costs
• Cash budgets are used to identify short-term
financial needs in advance
• The firm can then finance the shortfall

18-33