University of Science and Technology Beijing

Dongling School of Economics and management

Chapter 26 Short-Term Finance and Planning Dec. 2012 Dr. Xiao Ming USTB

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Key Concepts and Skills • Understand the components of the cash cycle and why it is important • Understand the pros and cons of the various short-term financing policies • Be able to prepare a cash budget • Understand the various options for short-term financing

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Chapter Outline 26.1 Tracing Cash and Net Working Capital 26.2 The Operating Cycle and the Cash Cycle 26.3 Some Aspects of Short-Term Financial Policy 26.4 Cash Budgeting 26.5 The Short-Term Financial Plan

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Balance Sheet Model of the Firm

Current Assets

Fixed Assets 1. Tangible 2. Intangible

Current Liabilities Net Working Capital

How much shortterm cash flow does a company need to pay its bills?

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Long-Term Debt

Shareholders’ Equity

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26.1 Tracing Cash and Net Working Capital • Current Assets are cash and other assets that are expected to be converted to cash within the year. – – – –

Cash Marketable securities Accounts receivable Inventory

• Current Liabilities are obligations that are expected to require cash payment within the year. – Accounts payable – Accrued wages – Taxes Dr. Xiao Ming USTB

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Defining Cash in Terms of Other Elements Net Working Fixed + = Capital Assets

Net Working Capital

= Cash +

LongTerm + Debt Other Current Assets

–

Equity

Current Liabilities

LongNet Working Fixed Cash = Term + Equity – – Capital Assets (excluding cash) Debt Dr. Xiao Ming USTB

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Defining Cash in Terms of Other Elements LongNet Working Fixed Cash = Term + Equity – – Capital Assets (excluding cash) Debt • An increase in long-term debt and or equity leads to an increase in cash—as does a decrease in fixed assets or a decrease in the non-cash components of net working capital. • The sources and uses of cash follow from this reasoning. Dr. Xiao Ming USTB

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26.2 The Operating Cycle and the Cash Cycle Raw material purchased Order Placed

Finished goods sold

Cash received

Stock Arrives

Inventory period

Accounts receivable period

Time

Accounts payable period Firm receives invoice

Cash paid for materials

Operating cycle Cash cycle Dr. Xiao Ming USTB

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The Operating Cycle and the Cash Cycle

Cash cycle = Operating cycle –

Accounts payable period

• In practice, the inventory period, the accounts receivable period, and the accounts payable period are measured by days in inventory, days in receivables, and days in payables, respectively.

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Example • 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 Dr. Xiao Ming USTB

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Example • 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 = 111.3 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 = 57.1 days

• Operating cycle = 111.3 + 57.1 = 168.4 days

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Example • Payables Period – Average payables = (75,000+100,000)/2 = 87,500 – Payables turnover = 820,000 / 87,500 = 9.37 times – Payables period = 365 / 9.37 = 38.9 days

• Cash Cycle = 168.4 – 38.9 = 129.5 days • We have to finance our inventory for 129.5 days. • If we want to reduce our financing needs, we need to look carefully at our receivables and inventory periods – they both seem excessive.

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26.3 Some Aspects of Short-Term Financial Policy • There are two elements of the policy that a firm adopts for short-term finance. – The size of the firm’s investment in current assets, usually measured relative to the firm’s level of total operating revenues. • Flexible • Restrictive

– Alternative financing policies for current assets, usually measured as the proportion of short-term debt to long-term debt. • Flexible • Restrictive Dr. Xiao Ming USTB

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Size of Investment in Current Assets • A flexible short-term finance policy would maintain a high ratio of current assets to sales. – Keeping large cash balances and investments in marketable securities – Large investments in inventory – Liberal credit terms

• A restrictive short-term finance policy would maintain a low ratio of current assets to sales. – Keeping low cash balances, no investment in marketable securities – Making small investments in inventory – Allowing no credit sales (thus no accounts receivable)

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Carrying Costs and Shortage Costs $

Minimum point

Total costs of holding current assets. Carrying costs

Shortage costs

CA*

Investment in Current Assets ($) Dr. Xiao Ming USTB

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Appropriate Flexible Policy $ Carrying costs

Minimum point

Total costs of holding current assets. Shortage costs

CA*

Investment in Current Assets ($)

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Appropriate Restrictive Policy $

Minimum point

Total costs of holding current assets.

Carrying costs

Shortage costs CA*

Investment in Current Assets ($)

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Alternative Financing Policies • A flexible short-term finance policy means a low proportion of short-term debt relative to long-term financing. • A restrictive short-term finance policy means a high proportion of short-term debt relative to long-term financing. • In an ideal world, short-term assets are always financed with short-term debt, and long-term assets are always financed with long-term debt. – In this world, net working capital is zero. Dr. Xiao Ming USTB

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26.4 Cash Budgeting • A cash budget is a primary tool of short-run financial planning. • The idea is simple: Record the estimates of cash receipts and disbursements. • Cash Receipts – Arise from sales, but we need to estimate when we actually collect

• Cash Outflow – – – –

Payments of Accounts Payable Wages, Taxes, and other Expenses Capital Expenditures Long-Term Financial Planning

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Example • Pet Treats Inc. specializes in gourmet pet treats and receives all income from sales • Sales estimates (in millions) – Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550

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

• 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 30% of sales – Interest and dividend payments are $50 – A major capital expenditure of $200 is expected in the second quarter

• The initial cash balance is $80 and the company maintains a minimum balance of $50 Dr. Xiao Ming USTB

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Example • 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.

Beginning Receivables Sales Cash Collections Ending Receivables

Q1 250 500 583 167 Dr. Xiao Ming USTB

Q2 167 600 567 200

Q3 200 650 633 217

Q4 217 800 750 267 21

Example • 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

Payment of accounts Wages, taxes and other expenses Capital expenditures Interest and dividend payments Total cash disbursements

Q1 275 150

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50 475

Q2 313 180 200 50 743

Q3 362 195

Q4 338 240

50 607

50 628 22

Example

Total cash collections Total cash disbursements Net cash inflow Beginning Cash Balance Net cash inflow Ending cash balance Minimum cash balance Cumulative surplus (deficit)

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Q1 583 475 108 80 108 188 -50 138

Q2 Q3 Q4 567 633 750 743 607 628 -176 26 122 188 12 38 -176 26 122 12 38 160 -50 -50 -50 -39 -12 110 23

26.5 The Short-Term Financial Plan • The most common way to finance a temporary cash deficit is to arrange a short-term loan. • Unsecured Loans – Line of credit (at the bank)

• Secured Loans – Accounts receivable can be either assigned or factored. – Inventory loans use inventory as collateral.

• Other Sources – Banker’s acceptance – Commercial paper

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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?

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