Chapter 16

Short-Term
Financial Planning

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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Key Concepts and Skills

• Be able to compute the operating and
cash cycles and understand why they are
important
• Understand the different types of short-
term financial policy
• Understand the essentials of short-term
financial planning

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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
• Short-Term Borrowing
• A Short-Term Financial Plan

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Sources and Uses of Cash

• Sources of Cash • Uses of Cash
– Obtaining financing: – Paying creditors or
• Increase in long-term stockholders
debt • Decrease in long-term
• Increase in equity debt
• Increase in current • Decrease in equity
liabilities • Decrease in current
liabilities
– Selling assets
– Buying assets
• Decrease in current
assets • Increase in current
assets
• Decrease in fixed
• Increase in fixed assets
assets

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The Operating Cycle

• The time it takes to receive inventory, sell
it, and collect on the receivables
generated from the sale of the inventory
• Operating cycle = inventory period +
accounts receivable period
– Inventory period = time inventory sits on the
shelf
– Accounts receivable period = time it takes to
collect on receivables
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The Cash Cycle

• The time between payment for inventory
and receipt from the sale of inventory
• Cash cycle = operating cycle – accounts
payable period
– Accounts payable period = time between
receipt of inventory and payment for it
• The cash cycle measures how long we
need to finance inventory and receivables

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Table 16.1

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Example Information
Item Beginning Ending Average

Inventory 200,000 300,000 250,000

Accounts 160,000 200,000 180,000

Receivable
Accounts 75,000 100,000 87,500
Payable
Net Sales = $1,150,000 Cost of Goods Sold = $820,000

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Example: Operating Cycle

• Inventory period
– Average inventory = (200,000+300,000)/2 =
250,000
– Inventory turnover = 820,000 / 250,000 = 3.28
times
– Inventory period = 365 / 3.28 = 111 days
• Receivables period
– Average receivables = (160,000+200,000)/2 =
180,000
– Receivables turnover = 1,150,000 / 180,000 = 6.39
times
– Receivables period = 365 / 6.39 = 57 days
• Operating cycle = 111 + 57 = 168 days
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Example: Cash Cycle

• Accounts Payable Period = 365 /
payables turnover
– Payables turnover = COGS / Average AP
• PT = 820,000 / 87,500 = 9.4 times
– Accounts payables period = 365 / 9.4 = 39
days
• Cash cycle = 168 – 39 = 129 days
• So, we have to finance our inventory
and receivables for 129 days

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Short-Term Financial Policy

• Flexible • Restrictive
(Conservative) Policy (Aggressive) Policy
– Large amounts of cash – Low cash and
and marketable marketable security
securities balances
– Large amounts of – Low inventory levels
inventory – Little or no credit sales
– Liberal credit policies (low accounts
(large accounts receivable)
receivable) – Relatively high levels of
– Relatively low levels of short-term liabilities
short-term liabilities
• Low liquidity
• High liquidity
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Carrying versus Shortage Costs

• Carrying costs
– Opportunity cost of owning current assets
versus long-term assets that pay higher returns
– Cost of storing larger amounts of inventory
• Shortage costs
– Order costs – the cost of ordering additional
inventory or transferring cash
– Stock-out costs – the cost of lost sales due to
lack of inventory, including lost customers

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Temporary versus Permanent Assets
• Are current assets temporary or
permanent?
– Both!
• Permanent current assets refer to the level
of current assets that the company retains
regardless of any seasonality in sales
• Temporary current assets refer to the
additional current assets that are added
when sales are expected to increase on a
seasonal basis
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Figure 16.4

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Choosing the Best Policy

• Best policy will be a combination of flexible
and restrictive policies
• Things to consider
– Cash reserves
– Maturity hedging
– Relative interest rates
• Compromise policy – borrow short-term to
meet peak needs, and maintain a cash
reserve for emergencies
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Figure 16.5

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Cash Budget
• Primary tool in short-run financial
planning
– Identify short-term needs and potential
opportunities
– Identify when short-term financing may be
required
• How it works
– Identify sales and cash collections
– Identify various cash outflows
– Subtract outflows from inflows and determine
investing and financing needs
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Example: Cash Budget Information

• Expected Sales by quarter (millions)
 Q1: $57; Q2: $66; Q3: $66; Q4: $90
• Beginning Accounts Receivable = $30
• Average collection period = 30 days
• Purchases from suppliers = 50% of next quarter’s
estimated sales
• Accounts payable period = 45 days
• Wages, taxes, and other expenses = 25% of sales
• Interest and dividends = $5 million per quarter
• Major expansion planned for quarter 2 costing $35
million
• Beginning cash balance = $5 million with minimum
cash balance of $2 million

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Example: Cash Budget – Cash
Collections
Q1 Q2 Q3 Q4

Beginning Receivables 30 19 22 22

Sales 57 66 66 90

Cash Collections = Beg. 68 63 66 82

Receivables + 2/3(Sales)

Ending Receivables = 19 22 22 30
1/3(Sales)

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Example: Cash Budget – Cash
Disbursements
Q1 Q2 Q3 Q4
Payment of A/P = 50% 28.50 33.00 33.00 45.00
of sales
Wages, taxes, other 14.25 16.50 16.50 22.50
expenses
Capital Expenditures 35.00

Long-term financing 5.00 5.00 5.00 5.00

(interest and dividends)
Total Disbursements 47.75 89.50 54.50 72.50

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Example: Cash Budget – Net
Cash Flow and Cash Balance
Q1 Q2 Q3 Q4
Total Cash Collections 68.00 63.00 66.00 82.00
Total Cash Disbursements 47.75 89.50 54.50 72.50

Net Cash Flow 20.25 (26.50) 11.50 9.5

Beginning Cash Balance 5.00 25.25 (1.25) 10.25
Net Cash Inflow 20.25 (26.50) 11.50 9.50
Ending Cash Balance 25.25 (1.25) 10.25 19.75
Minimum Cash Balance -2.00 -2.00 -2.00 -2.00
Cumulative surplus 23.25 (3.25) 8.25 17.75
(deficit)

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Short-Term Borrowing
• Unsecured loans
– Line of credit – prearranged agreement with a bank that
allows the firm to borrow up to a certain amount on a
short-term basis
– Committed – formal legal arrangement that may require
a commitment fee and generally has a floating interest
rate
– Non-committed – informal agreement with a bank that
is similar to credit card debt for individuals
– Revolving credit – non-committed agreement with a
longer time between evaluations
• Secured loans – loan secured by receivables,
inventory, or both

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Example: Factoring
• Selling receivables to someone else at a
discount
• Example: You have an average of $1 million
in receivables and you borrow money by
factoring receivables with a discount of 2.5%.
The receivables turnover is 12 times per year.
• What is the APR?
– Period rate = .025/.975 = 2.564%
– APR = 12(2.564%) = 30.769%
• What is the effective rate?
– EAR = 1.0256412 – 1 = 35.502%

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Short-Term Financial Plan

Q1 Q2 Q3 Q4
Beginning Cash 5.00 25.25 2.00 10.05
Net Cash Inflow 20.25 (26.50) 11.50 9.50
New Short-Term Debt 0.00 3.25 0.00 0.00
Interest on Short-Term Debt 0.00 0.00 0.20 0.00
Short-Term Debt Repayment 0.00 0.00 3.25 0.00
Ending Cash Balance 25.25 2.00 10.05 19.55
Minimum Cash Balance -2.00 -2.00 -2.00 -2.00
Cumulative Surplus (Deficit) 23.25 0.00 8.05 17.55
Beginning Short-Term Debt 0.00 000 3.25 0.00
Change in Short-Term Debt 0.00 3.25 -3.25 0.00
Ending Short-Term Debt 0.00 3.25 0.00 0.00

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Quick Quiz
• Suppose your average inventory is $10,000,
your average receivables balance is $9,000,
and your average payables balance is $4,000.
Net sales are $100,000 and cost of goods
sold is $50,000.
– What are the operating cycle and the cash
cycle?
• What are the differences between flexible and
restrictive short-term financial policies?
• What factors do we need to consider when
choosing a financial policy?
• What factors go into determining a cash
budget and why is it valuable?

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Comprehensive Problem
• With average accounts receivable of $5
million, and credit sales of $24 million, you
factor receivables by discounting them
2%. What is the effective rate of interest?

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