Short-Term Finance and Planning

Transcription

1 Short-Term Finance and Planning Chapter 26 PART SEVEN On 1 January 2005 retailing giant Wal-Mart began requiring its 100 largest suppliers to put radio frequency identification (RFID) tags on cases and pallets shipped to three of its distribution centres and 100 of its stores. By October 2005 the company had expanded the requirement to three additional distribution centres and 900 more stores. The next 200 largest suppliers also had to begin adding the RFID tags. RFID tags are essentially high-tech replacements for bar codes. The advantage is that they can be read from a distance, so an entire warehouse can be scanned in seconds. RFID tag sales are expected to grow from about 700 million ($760 million) in 2003 to about 1.98 billion ($2.2 billion) in So why the rapid growth in high-tech bar codes? Look no further than Wal-Mart for the answer. Specifically, the company thought it would save $6.7 billion in labour costs by eliminating individual scans, $600 million by reducing out-of-stock items, $575 million by reducing theft, $300 million with better tracking, and $180 million by reducing inventory. The total cost savings for Wal-Mart are estimated at $8.35 billion per year! As this example suggests, proper management of short-term assets such as inventory can have a significant impact on the profitability of a company, and the value investors place on it. Short-term financial planning is one activity that concerns everyone in business. As this chapter illustrates, such planning demands, among other things, sales projections from marketing, cost numbers from accounting, and inventory requirements from operations Tracing Cash and Net Working Capital In this section we trace the components of cash and net working capital as they change from one year to the next. Our goal is to describe the short-term operating activities of the firm, and their impact on cash and working capital. Current assets are cash and other assets that are expected to be converted to cash within the year. Current assets are presented in the balance sheet in order of their accounting liquidity the ease with which they can be converted to cash at a fair price, and the time it takes to do so. Table 26.1 gives the balance sheet and income statement of the global pharmaceutical firm Sanofi-Aventis SA for 2005, 2006 and The items found in the current asset section of the Sanofi-Aventis balance sheet are cash and cash equivalents, financial assets to be sold or expire within one year, other current assets, accounts receivable, inventories, and assets held for sale. Analogous to their investment in current assets, firms use several kinds of short-term debt, called current liabilities. Current liabilities are obligations that are expected to require cash payment within one year or within the operating cycle, whichever is shorter. 1 The items found as current liabilities are accounts payable, other current liabilities (such as accrued wages, taxes, and other expenses payable), and short-term debt and long-term debt to be paid off within one year.

2 _ 720 Chapter 26 Short-Term Finance and Planning TABLE 26.1 (C million) Note Consolidated statement of financial position ASSETS Property, plant and equipment D.3 6,538 6,219 6,184 Goodwill D.4 27,199 28,472 30,234 Intangible assets D.4 19,182 23,738 30,229 Investments in associates D.6 2,493 2,637 2,477 Financial assets non-current D.7 D.20 1,037 1,045 1,318 Deferred tax assets D.14 2,912 3,492 3,382 Non-current assets 59,361 65,603 73,824 Assets held for sale D Inventories D.9 3,729 3,659 3,430 Accounts receivable D.10 4,904 5,032 5,021 Other current assets D.11 2,126 2,208 2,434 Financial assets current D.12 D Cash and cash equivalents D.13 D.17 1,711 1,153 1,249 Current assets 12,553 12,160 13,121 TOTAL ASSETS 71,914 77,763 86,945 (C million) Note LIABILITIES AND EQUITY Equity attributable to equity D ,542 45,600 46,128 holders of the company Minority interests D Total equity 44,719 45,820 46,317 Long-term debt D.17 3,734 4,499 4,750 Provisions and other non-current D.18 6,857 7,920 8,250 liabilities Deferred tax liabilities D.14 6,935 9,246 12,208 Non-current liabilities 17,526 21,665 25,208 Liabilities related to assets held D for sale Accounts payable 2,749 3,008 3,193 Other current liabilities D.19 4,713 4,825 5,543 Short-term debt and current D.17 2,207 2,445 6,425 portion of long-term debt Current liabilities 9,669 10,278 15,420 TOTAL LIABILITIES AND EQUITY 71,914 77,763 86,945 Table 26.1 Financial statements of Sanofi-Aventis SA 26.2 Defining Cash in Terms of Other Elements Now we shall define cash in terms of the other elements of the statement of financial position or balance sheet. The balance sheet equation is _ Net working capital + Non-current assets = Non-Current Liabilities + Equity (26.1)

3 Defining Cash in Terms of Other Elements 721 TABLE 26.1 (C million) Consolidated income statement Year ended 2007 Year ended 2006 Year ended 2005 Net sales 28,052 28,373 27,311 Other revenues 1,155 1,116 1,202 Cost of sales (7,571) (7,587) (7,566) Gross profit 21,636 21,902 20,947 Research and development expenses (4,537) (4,430) (4,044) Selling and general expenses (7,554) (8,020) (8,250) Other operating income Other operating expenses (307) (116) (124) Amortization of intangibles (3,654) (3,998) (4,037) Operating income before restructuring, 6,106 5,729 4,753 impairment of property, plant and equipment and intangibles, gains and losses on disposals, and litigation Restructuring costs (137) (274) (927) Impairment of property, plant and equipment (58) (1,163) (972) and intangibles Gains and losses on disposals, and litigation Operating income 5,911 4,828 2,888 Financial expenses (329) (455) (532) Financial income Income before tax and associates 5,772 4,748 2,643 Income tax expense (687) (800) (477) Share of profit/loss of associates Net income 5,682 4,399 2,593 Net income attributable to minority interests Net income attributable to equity holders of the Company 5,263 4,006 2,258 Average number of shares outstanding (million) 1, , ,336.5 Average number of shares outstanding after 1, , ,346.5 dilution (million) Basic earnings per share (in euros) Diluted earnings per share (in euros) Table 26.1 Continued Net working capital is cash plus the other elements of net working capital: Net working capital = Cash + Other current assets - Current liabilities (26.2) Substituting Eq. (26.2) into Eq. (26.1) yields Other current Cash + - Current liabilities = assets Non-current Non-current + Equity - (26.3) liabilities assets and rearranging, we find that

4 _ 722 Chapter 26 Short-Term Finance and Planning Cash Non-current = + Equity - liabilities Net working capital (excluding cash) Non-current - (26.4) assets The natural interpretation of Eq. (26.4) is that increasing non-current liabilities and equity and decreasing non-current assets and net working capital (excluding cash) will increase cash to the firm. The Sources and Uses of Cash We first introduced the statement of cash flows in Chapter 3. This is the accounting statement that describes the sources and uses of cash. In this section we look at where cash comes from, and how it is used. From the right side of Eq. (26.4) we can see that an increase in non-current liabilities or equity leads to an increase in cash. Moreover, a decrease in net working capital or non-current assets leads to an increase in cash. In addition, the sum of net income and depreciation increases cash, whereas dividend payments decrease cash. This reasoning allows an accountant to create a statement of cash flows, which shows all the transactions that affect a firm s cash position. Let us trace the changes in cash for Sanofi-Aventis during From the firm s statement of cash flows (Table 26.2), we find that Sanofi-Aventis generated cash as follows: 1 Generated cash flow of $7,917 million from operations. 2 Made $329 million on selling property, plant and equipment and intangible assets. 3 Issued new shares, raising $271 million. 4 Took out new long-term debt of $1,639 million. Sanofi-Aventis used cash for the following reasons: 1 Paid off taxes of $1,476 million. 2 Increased inventories by $89 million. TABLE 26.2 (C million) Consolidated statements of cash flows Year ended 2007 Year ended 2006 Year ended 2005 Net income attributable to equity holders of 5,263 4,006 2,258 the company Minority increase, excluding BMS Share of undistributed earnings of associates Depreciation, amortization and impairment of 4,664 6,113 5,951 property, plant and equipment and intangible assets Gains and losses on disposals of non-current assets, (64) (558) (125) net of tax Net change in deferred taxes (1,476) (2,463) (2,100) Net change in provisions (247) Cost of employee benefits (stock options and capital increase) Impact of work down of Aventis inventories remeasured at fair value, net of tax Unrealized gains and losses recognized in income (506) (5) (56) (60) _ Table 26.2 Sources and uses of cash in Sanofi-Aventis SA

5 Defining Cash in Terms of Other Elements 723 TABLE 26.2 (C million) Consolidated statements of cash flows Year ended 2007 Year ended 2006 Year ended 2005 Operating cash flow before changes in working 7,917 7,610 6,637 capital (Increase)/decrease in inventories (89) (372) (586) (Increase)/decrease in accounts receivable (60) (241) (738) Increase/(decrease) in accounts payable and accrued (156) (77) 474 expenses Net change in other current assets, financial assets - current and other current liabilities (506) (316) 611 Net cash provided by operating activities 7,106 6,604 6,398 Acquisitions of property, plant and equipment and (1,610) (1,454) (1,143) intangible assets Acquisitions of investments in consolidated (214) (509) (692) undertakings, net of cash acquired Acquisitions of available-for-sale financial assets (221) (4) (4) Proceeds from disposals of property, plant and 329 1, equipment, intangible assets and other non-current assets, net of tax Net change in loans and other non-current financial assets 3 5 Net cash used in investing activities (1,716) (790) (1,101) Issuance of sanofi-aventis shares Dividends paid: to sanofi-aventis shareholders (2,364) (2,042) (1,604) to minority shareholders, excluding BMS (9) (8) (10) Additional long-term borrowings 1, ,268 Repayments of long-term borrowings (2,065) (1,351) (7,959) Net change in short-term borrowings (509) (3,674) (2,099) Acquisition of treasury shares (1,806) Disposals of treasury shares, net of tax Net cash provided by (used in) financing activities (4,820) (5,854) (5,985) Impact of exchange rates on cash and cash equivalents (12) (56) 97 Net change in cash and Cash equivalents 558 (96) (591) Cash and cash equivalents, beginning of period 1,153 1,249 1,840 Cash and cash equivalents, end of period 1,711 1,153 1,249 Table 26.2 Continued 3 Increased accounts receivable by $60 million. 4 Decreased accounts payable and accrued expenses by $156 million. 5 Purchased $1,610 of new property, plant and equipment and intangible assets. 6 Purchased $221 million of financial assets. 7 Paid dividends of $2,373 (= $2,364 + $9) million. 8 Repaid $2,065 million of long-term debt.

6 _ 724 Chapter 26 Short-Term Finance and Planning 9 Reduced short-term debt by $509 million. 10 Purchased $1,806 million of treasury shares. This example illustrates the difference between a firm s cash position on the balance sheet and its cash flows from operations The Operating Cycle and the Cash Cycle Short-term finance is concerned with the firm s short-term operating activities. A typical manufacturing firm s short-term operating activities consist of a sequence of events and decisions: Events Decisions 1 Buying raw materials. 1 How much inventory to order? 2 Paying cash for purchases. 2 To borrow or draw down cash balance? 3 Manufacturing the product. 3 What choice of production technology? 4 Selling the product. 4 To offer cash terms or credit terms to customers? 5 Collecting cash. 5 How to collect cash? These activities create patterns of cash inflows and cash outflows that are both unsynchronized and uncertain. They are unsynchronized because the payment of cash for raw materials does not happen at the same time as the receipt of cash from selling the product. They are uncertain because future sales and costs are not known with certainty. Figure 26.1 depicts the short-term operating activities and cash flows for a typical manufacturing firm along the cash flow time line. The operating cycle is the interval between the arrival of inventory stock and the date when cash is collected from receivables. The cash cycle begins when cash is paid for materials, and ends when cash is collected from receivables. The cash flow time line consists of an operating cycle and a cash cycle. The need for short-term financial decision-making is suggested by the gap between the cash inflows FIGURE 26.1 Raw material purchased Order placed Stock arrives Finished goods sold Cash received Inventory period Accounts payable period Accounts receivable period Time Firm receives invoice Cash paid for materials Operating cycle Cash cycle The operating cycle is the period from the arrival of stock until the receipt of cash. (Sometimes the operating cycle is defined to include the time from placement of the order until arrival of the stock.) The cash cycle begins when cash is paid for materials, and ends when cash is collected from receivables. _ Figure 26.1 Cash flow time line and the short-term operating activities of a typical manufacturing firm

7 The Operating Cycle and the Cash Cycle 725 and cash outflows. This is related to the lengths of the operating cycle and the accounts or trades payable period. This gap can be filled either by borrowing or by holding a liquidity reserve for marketable securities. The gap can be shortened by changing the inventory, receivable and payable periods. Now we take a closer look at the operating cycle. The length of the operating cycle is equal to the sum of the lengths of the inventory and accounts receivable periods. The inventory period is the length of time required to order raw materials, produce and sell a product. The accounts receivable period is the length of time required to collect cash receipts. The cash cycle is the time between cash disbursement and cash collection. It can be thought of as the operating cycle less the accounts payable period: Cash cycle = Operating cycle - Accounts payable period The accounts payable period is the length of time for which the firm is able to delay payment on the purchase of various resources, such as labour and raw materials. 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. We illustrate how the operating cycle and the cash cycle can be measured in the following example. Cash Cycle EXAMPLE Sanofi-Aventis SA is a global pharmaceutical firm with the statement of financial position 26.1 and income statement shown in Table 26.1 for 2005, 2006 and We can determine the operating cycle and the cash cycle for Sanofi-Aventis after calculating the appropriate ratios for inventory, receivables and payables. Consider inventory first. The average inventory is $ 3, 729 million + $ 3, 659 million Average inventory = 2 = $ 3, 694 million The terms in the numerator are the ending inventory in 2007 and 2006, respectively. We next calculate the inventory turnover ratio: Cost of goods sold Inventory turnover ratio = Average inventory $ 7, 571 million = $ 3, 694 million = This implies that the inventory cycle occurs 2.05 times a year. Finally, we calculate days in inventory: 365 days Days in inventory = 205. = days Our calculation implies that the inventory cycle is slightly more than 178 days. We perform analogous calculations for receivables and payables: 2 Average accounts receivable $ 4,903 million + $ 5,032million = 2 = $4, million

8 _ 726 Chapter 26 Short-Term Finance and Planning Average receivable turnover Days in receivables Average payables Accounts payable deferral period Credit sales = Average accounts receivable 28,052 million = $ $ 4,967.5 million = = 565. = days $ 2,749 million + $3, 008 million = 2 = $2, million Cost of goods sold = Average payables 7,571 million = $ $ 2,878.5 million = 263. Days in = payables = days The preceding calculations allow us to determine both the operating cycle and the cash cycle: Operating cycle Days in Days in = + inventory receivables = days days = days Cash cycle = Operating cycle - Days inpayables = days days = days The cash cycle is longer in some industries than in others because of different products and industry practices. Table 26.3 illustrates this point by comparing the current assets and current liabilities for four different companies. Of the four, Wal-Mart has the highest level of inventories. Does this mean Wal-Mart is less efficient? Probably not; instead, it is likely that the relatively high inventory levels are consistent with the industry. Wal-Mart needs a higher level of inventory to satisfy customers who walk into its stores. In contrast, Dell makes products to order, so its inventory levels are lower. What might seem surprising is Boeing s relatively low level of inventory, especially given that much of its inventory consists of aircraft under construction. However, notice that the current assets for Boeing are only 37 per cent of total assets, implying that fixed assets are large, as you would expect from such a capital-intensive company plus Boeing has been aggressive in recent years in reducing its inventory. In contrast, Amazon s fixed assets are small relative to its current assets, which again is what we would expect given the nature of its business. _ 26.4 Some Aspects of Short-Term Financial Policy The policy that a firm adopts for short-term finance will be composed of at least two elements:

9 Some Aspects of Short-Term Financial Policy 727 TABLE 26.3 Amazon.com (%) Boeing (%) Dell (%) Wal-Mart (%) Cash and near cash Marketable securities Accounts receivable Inventories Other current assets Total current assets Accounts payable Short-term borrowings Other short-term liabilities Current liabilities Table 26.3 Current assets and current liabilities as a percentage of total assets for selected companies 1 The size of the firm s investment in current assets: This is usually measured relative to the firm s level of total operating revenues. A flexible or accommodative short-term financial policy would maintain a high ratio of current assets to sales. A restrictive short-term financial policy would entail a low ratio of current assets to sales. 2 The financing of current assets: This is measured as the proportion of short-term debt to long-term debt. A restrictive short-term financial policy means a high proportion of shortterm debt relative to long-term financing, and a flexible policy means less short-term debt and more long-term debt. The Size of the Firm s Investment in Current Assets Flexible short-term financial policies include: Keeping large balances of cash and marketable securities Making large investments in inventory Granting liberal credit terms, which results in a high level of accounts receivable Restrictive short-term financial policies are: Keeping low cash balances and no investment in marketable securities Making small investments in inventory Allowing no credit sales and no accounts receivable Determining the optimal investment level in short-term assets requires an identification of the different costs of alternative short-term financing policies. The objective is to trade off the cost of restrictive policies against those of the flexible ones to arrive at the best compromise. Current asset holdings are highest with a flexible short-term financial policy and lowest with a restrictive policy. Thus flexible short-term financial policies are costly in that they require higher cash outflows to finance cash and marketable securities, inventory, and accounts receivable. However, future cash inflows are highest with a flexible policy. Sales are stimulated by the use of a credit policy that provides liberal financing to customers. A large amount of inventory on hand ( on the shelf ) provides a quick delivery service to customers and increases in sales. 3 In addition, the firm can probably charge higher prices for the quick delivery service and the liberal credit terms of flexible policies. A flexible policy may also result in fewer production stoppages because of inventory shortages. 4

10 _ 728 Chapter 26 Short-Term Finance and Planning Managing current assets can be thought of as involving a trade-off between costs that rise with the level of investment and costs that fall with the level of investment. Costs that rise with the level of investment in current assets are called carrying costs. Costs that fall with increases in the level of investment in current assets are called shortage costs. Carrying costs are generally of two types. First, because the rate of return on current assets is low compared with that of other assets, there is an opportunity cost. Second, there is the cost of maintaining the economic value of the item. For example, the cost of warehousing inventory belongs here. Determinants of Corporate Liquid Asset Holdings Firms with high holdings of liquid assets will have High-growth opportunities High-risk investments Small firms Low-credit firms Firms with low holdings of liquid assets will have Low-growth opportunities Low-risk investments Large firms High-credit firms Firms will hold more liquid assets (i.e., cash and marketable securities) to ensure that they can continue investing when cash flow is low relative to positive NPV investment opportunities. Firms that have good access to capital markets will hold less liquid assets. Source: Tim Opler, Lee Pinkowitz, René Stulz and Rohan Williamson, The determinants and implication of corporate cash holdings, Journal of Financial Economics, vol. 52 (1999). Shortage costs are incurred when the investment in current assets is low. If a firm runs out of cash, it will be forced to sell marketable securities. If a firm runs out of cash and cannot readily sell marketable securities, it may need to borrow, or default on an obligation. (This general situation is called cash-out.) If a firm has no inventory (a stockout) or if it cannot extend credit to its customers, it will lose customers. There are two kinds of shortage costs: 1 Trading or order costs: Order costs are the costs of placing an order for more cash (brokerage costs) or more inventory ( production set-up costs). 2 Costs related to safety reserves: These are costs of lost sales, lost customer goodwill, and disruption of production schedules. _ Figure 26.2 illustrates the basic nature of carrying costs. The total costs of investing in current assets are determined by adding the carrying costs and the shortage costs. The minimum point on the total cost curve (CA*) reflects the optimal balance of current assets. The curve is generally quite flat at the optimum, and it is difficult, if not impossible, to find the precise optimal balance of shortage and carrying costs. Usually, we are content with a choice near the optimum. If carrying costs are low, or shortage costs are high, the optimal policy calls for substantial current assets. In other words, the optimal policy is a flexible one. This is illustrated in the middle graph of Fig If carrying costs are high, or shortage costs are low, the optimal policy is a restrictive one. That is, the optimal policy calls for modest current assets. This is illustrated in the bottom graph of the figure. Opler, Pinkowitz, Stulz and Williamson examine the determinants of holdings of cash and marketable securities by publicly traded firms. 5 They find evidence that firms behave according to the static trade-off model described earlier. Their study focuses only on liquid assets (i.e.,

11 Some Aspects of Short-Term Financial Policy 729 FIGURE 26.2 Cost (e.g. or ) Minimum point Total cost of holding current assets Carrying costs Shortage costs CA* The optimal amount of current assets. This point minimizes costs. Amount of current assets (CA) Flexible policy Cost (e.g. or ) Minimum point Total cost Carrying costs Shortage costs CA* Amount of current assets (CA) Restrictive policy Minimum point Cost (e.g. or ) Total cost Carrying costs Shortage costs CA* Amount of current assets (CA) Carrying costs increase with the level of investment in current assets. They include both opportunity costs and the costs of maintaining the asset s economic value. Shortage costs decrease with increases in the level of investment in current assets. They include trading costs and the costs of running out of the current asset (for example, being short of cash). Figure 26.2 Carrying costs and shortage costs

12 _ 730 Chapter 26 Short-Term Finance and Planning FIGURE 26.3 Current assets = Short-term debt Cost (e.g. or ) Fixed assets Long-term debt plus equity In an ideal world, net working capital is always zero, because short-term assets are financed by short-term debt Time Figure 26.3 Financing policy for an idealized economy cash and market securities), so that carrying costs are the opportunity costs of holding liquid assets and shortage costs are the risks of not having cash when investment opportunities are good. Alternative Financing Policies for Current Assets In the previous section we examined the level of investment in current assets. Now we turn to the level of current liabilities, assuming the investment in current assets is optimal. An Ideal Model In an ideal economy short-term assets can always be financed with shortterm debt, and long-term assets can be financed with long-term debt and equity. In this utopian economy, net working capital is always zero. Imagine the simple case of a grain elevator operator. Grain elevator operators buy crops after harvest, store them, and sell them during the year. They have high inventories of grain after the harvest, and end with low inventories just before the next harvest. Bank loans with maturities of less than one year are used to finance the purchase of grain. These loans are paid with the proceeds from the sale of grain. The situation is shown in Fig Long-term assets are assumed to grow over time, whereas current assets increase at the end of the harvest and then decline during the year. Short-term assets end at zero just before the next harvest. These assets are financed by short-term debt, and long-term assets are financed with long-term debt and equity. Net working capital current assets minus current liabilities is always zero. _ Different Strategies in Financing Current Assets Current assets cannot be expected to drop to zero in the real world, because a long-term rising level of sales will result in some permanent investment in current assets. A growing firm can be thought of as having a permanent requirement for both current assets and long-term assets. This total asset requirement will exhibit balances over time reflecting (a) a secular growth trend, (b) a seasonal variation around the trend, and (b) unpredictable day-to-day and month-to-month fluctuations. This is depicted in Figure (We have not tried to show the unpredictable day-to-day and month-to-month variations in the total asset requirement.) Now let us look at how this asset requirement is financed. First, consider the strategy (strategy F in Fig. 26.5) where long-term financing covers more than the total asset requirement, even at seasonal peaks. The firm will have excess cash available for investment in marketable securities when the total asset requirement falls from peaks. Because this approach implies chronic short-term cash surpluses and a large investment in net working capital, it is considered a flexible strategy.

13 Some Aspects of Short-Term Financial Policy 731 FIGURE 26.4 Cost (e.g. or ) Seasonal variation Secular growth in fixed assets and permanent current assets Total asset requirement Time Figure 26.4 The total asset requirement over time FIGURE 26.5 Marketable securities Strategy F Total asset requirement Cost (e.g. or ) Long-term financing Time Strategy R Total asset requirement Strategy F always implies a short-term cash surplus and a large investment in cash and marketable securities. Strategy R uses long-term financing for secular asset requirements only, and short-term borrowing for seasonal variations. Cost (e.g. or ) Long-term financing Short-term financing Time Figure 26.5 Alternative asset financing policies When long-term financing does not cover the total asset requirement, the firm must borrow short-term to make up the deficit. This restrictive strategy is labelled strategy R in Fig Which Is Best? What is the most appropriate amount of short-term borrowing? There is no definitive answer. Several considerations must be included in a proper analysis:

14 _ 732 Chapter 26 Short-Term Finance and Planning 1 Cash reserves: The flexible financing strategy implies surplus cash and little short-term borrowing. This strategy reduces the probability that a firm will experience financial distress. Firms may not need to worry as much about meeting recurring short-term obligations. However, investments in cash and marketable securities are zero net present value investments at best. 2 Maturity hedging: Most firms finance inventories with short-term bank loans and fixed assets with long-term financing. Firms tend to avoid financing long-lived assets with short-term borrowing. This type of maturity mismatching would necessitate frequent financing and is inherently risky, because short-term interest rates are more volatile than longer rates. This type of activity was precisely the reason why many banks found themselves in difficulty during the global credit crunch of 2007 and Banks financed long-term assets (loans and mortgages granted to borrowers) by short-term borrowing. In some cases this borrowing had just a 30-day maturity. For example, Northern Rock plc, the British bank that requested emergency central bank funding in September 2007, funded its loans and mortgages by 61 per cent short-term borrowing and 39 per cent deposits just before it made the request to the Bank of England. Because of the collapse in credit, the funding base of Northern Rock collapsed. 3 Term structure: Short-term interest rates are normally lower than long-term interest rates. This implies that, on average, it is more costly to rely on long-term borrowing than on short-term borrowing Cash Budgeting The cash budget is a primary tool of short-term financial planning. It allows the financial manager to identify short-term financial needs (and opportunities). It will tell the manager the required borrowing for the short term. It is the way of identifying the cash flow gap on the cash flow time line. The idea of the cash budget is simple: it records estimates of cash receipts and disbursements. We illustrate cash budgeting with the following example of Fun Toys. EXAMPLE 26.2 Cash Collections All of Fun Toys cash inflows come from the sale of toys. Cash budgeting for Fun Toys starts with a sales forecast for the next year, by : First Second Third Fourth Sales (C millions) Fun Toys fiscal year starts on 1 July. Fun Toys sales are seasonal, and are usually very high in the second because of holiday sales. But Fun Toys sells to department stores on credit, and sales do not generate cash immediately. Instead, cash comes later from collections on accounts receivable. Fun Toys has a 90-day collection period, and 100 per cent of sales are collected the following. In other words This relationship implies that Collections = Last s sales _ Accounts receivable at end of last = Last s sales (26.5)

15 Cash Budgeting 733 We assume that sales in the fourth of the previous fiscal year were $100 million. From Eq. (26.5) we know that accounts receivable at the end of the fourth of the previous fiscal year were $100 million, and collections in the first of the current fiscal year are $100 million. The first sales of the current fiscal year of $100 million are added to the accounts receivable, but $100 million of collections are subtracted. Therefore Fun Toys ended the first with accounts receivable of $100 million. The basic relation is Ending accounts Starting accounts = + Sales - Collections receivable receivable Table 26.4 shows cash collections for Fun Toys for the next four s. Though collections are the only source of cash here, this need not always be the case. Other sources of cash could include sales of assets, investment income, and long-term financing. Cash Outflow Next, we consider cash disbursements. They can be put into four basic categories, as shown in Table Payments of accounts payable: These are payments for goods or services, such as raw materials. These payments will generally be made after purchases. Purchases will depend on the sales forecast. In the case of Fun Toys, assume that: Payments = Last s purchases Purchases = 1/2 next s sales forecast 2 Wages, taxes, and other expenses: This category includes all other normal costs of doing business that require actual expenditures. Depreciation, for example, is often thought of as a normal cost of business, but it requires no cash outflow. 3 Capital expenditures: These are payments of cash for long-lived assets. Fun Toys plans a major capital expenditure in the fourth. 4 Long-term financing: This category includes interest and principal payments on long-term outstanding debt and dividend payments to shareholders. The total forecast outflow appears in the last line of Table The Cash Balance The net cash balance appears in Table 26.6, and a large net cash outflow is forecast in the second. This large outflow is not caused by an inability to earn a profit. Rather, it results from delayed collections on sales. This results in a cumulative cash shortfall of $30 million in the second. Fun Toys had established a minimum operating cash balance equal to $5 million to facilitate transactions, protect against unexpected contingencies, and maintain compensating balances at its banks. This means that it has a cash shortfall in the second equal to $35 million. TABLE 26.4 First Second Third Fourth Sales Cash collections Starting receivables Ending receivables Table 26.4 Sources of cash (in C millions)

16 _ 734 Chapter 26 Short-Term Finance and Planning TABLE 26.5 First Second Third Fourth Sales Purchases Uses of cash Payments of accounts payable Wages, taxes, and other expenses Capital expenditures Long-term financing expenses: interest and dividends Total uses of cash Table 26.5 Disbursement of cash (in C millions) TABLE 26.6 First Second Third Fourth Total cash receipts Total cash disbursements Net cash flow 20 (50) 85 (30) Cumulative excess cash balance 20 (30) Minimum cash balance Cumulative finance surplus (deficit) Requirement 15 (35) Table 26.6 The cash balance (in C millions) 26.6 The Short-Term Financial Plan Fun Toys has a short-term financing problem. It cannot meet the forecast cash outflows in the second from internal sources. Its financing options include: (a) unsecured bank borrowing; (b) secured borrowing; and (c) other sources. Unsecured Loans _ The most common way to finance a temporary cash deficit is to arrange a short-term unsecured bank loan. Firms that use short-term bank loans usually ask their bank for either a noncommitted or a committed line of credit. A non-committed line is an informal arrangement that allows firms to borrow up to a previously specified limit without going through the normal paperwork. The interest rate on the line of credit is usually set equal to the bank s prime lending rate plus an additional percentage. Committed lines of credit are formal legal arrangements, and usually involve a commitment fee paid by the firm to the bank (usually the fee is approximately 0.25 per cent of the total committed funds per year). For larger firms the interest rate is often tied to the Interbank Offered Rate (LIBOR or EURIBOR) or to the bank s cost of funds, rather than the benchmark rate. Mid-sized and smaller firms often are required to keep compensating balances in the bank.

17 The Short-Term Financial Plan 735 Compensating balances are deposits the firm keeps with the bank in low-interest or noninterest-bearing accounts. Compensating balances are commonly of the order of 2 to 5 per cent of the amount used. By leaving these funds with the bank without receiving interest, the firm increases the effective interest earned by the bank on the line of credit. For example, if a firm borrowing 100,000 must keep 5,000 as a compensating balance, the firm effectively receives only 95,000. A stated interest rate of 10 per cent implies yearly interest payments of 10,000 (= 100, ). The effective interest rate is per cent (= 10,000/ 95,000). Secured Loans Banks and other finance companies often require security for a loan. Security for short-term loans usually consists of accounts receivable or inventories. Under accounts receivable financing, receivables are either assigned or factored. Under assignment, the lender not only has a lien on the receivables but also has recourse to the borrower. Factoring involves the sale of accounts receivable. The purchaser, who is called a factor, must then collect on the receivables. The factor assumes the full risk of default on bad accounts. As the name implies, an inventory loan uses inventory as collateral. Some common types of inventory loans are: 1 Blanket inventory lien: The blanket inventory lien gives the lender a lien against all the borrower s inventories. 2 Trust receipt: Under this arrangement the borrower holds the inventory in trust for the lender. The document acknowledging the loan is called the trust receipt. Proceeds from the sale of inventory are remitted immediately to the lender. 3 Field warehouse financing: In field warehouse financing, a public warehouse company supervises the inventory for the lender. Other Sources A variety of other sources of short-term funds are employed by corporations. The most important of these are the issuance of commercial paper and financing through banker s acceptances. Commercial paper consists of short-term notes issued by large, highly rated firms. Typically these notes are of short maturity, ranging up to 270 days (beyond that limit the firm will normally be required to file a registration statement with the appropriate stock exchange). Because the firm issues these directly, and because it usually backs the issue with a special bank line of credit, the rate the firm obtains is often significantly below the rate the bank would charge it for a direct loan. A banker s acceptance is an agreement by a bank to pay a sum of money. These agreements typically arise when a seller sends a bill or draft to a customer. The customer s bank accepts this bill and notes the acceptance on it, which makes it an obligation of the bank. In this way a firm that is buying something from a supplier can effectively arrange for the bank to pay the outstanding bill. Of course, the bank charges the customer a fee for this service. Summary and Conclusions 1 This chapter introduced the management of short-term finance. Short-term finance involves short-lived assets and liabilities. We traced and examined the short-term sources and uses of cash as they appear on the firm s financial statements. We saw how current assets and current liabilities arise in the short-term operating activities and the cash cycle of the firm. From an accounting perspective, short-term finance involves net working capital.

18 _ 736 Chapter 26 Short-Term Finance and Planning Managing short-term cash flows involves the minimization of costs. The two major costs are carrying costs (the interest and related costs incurred by overinvesting in short-term assets such as cash) and shortage costs (the cost of running out of short-term assets). The objective of managing short-term finance and short-term financial planning is to find the optimal trade-off between these costs. In an ideal economy a firm could perfectly predict its short-term uses and sources of cash, and net working capital could be kept at zero. In the real world net working capital provides a buffer that lets the firm meet its ongoing obligations. The financial manager seeks the optimal level of each of the current assets. The financial manager can use the cash budget to identify short-term financial needs. The cash budget tells the manager what borrowing is required or what lending will be possible in the short term. The firm has a number of possible ways of acquiring funds to meet short-term shortfalls, including unsecured and secured loans. Questions and Problems CONCEPT Net Working Capital Why is short-term financial planning crucial to a company? 2 Cash Review the different ways in which cash can increase or decrease in a firm. Use the accounting equation to support your answer. 3 The Operating Cycle and Cash Cycle What are some of the characteristics of a firm with a long operating cycle? Similarly, what are some of the characteristics of a firm with a long cash cycle? 4 Short-term Financial Policy Review the various financing policies to manage current assets. 5 Cash Budgeting Explain what is meant by cash budgeting. 6 The Short-term Financial Plan Review the various ways a firm can finance a short-term cash deficit. REGULAR Sources and Uses For the year just ended, you have gathered the following information about the Mia plc: (a) (b) A 200 dividend was paid. Trade payables increased by 500. (c) (d) (e) Fixed asset purchases were 900. Inventories increased by 625. Long-term debt decreased by 1,200. Label each as a source or use of cash and describe its effect on the firm s cash balance. 8 Cost of Current Assets Loftis Manufacturing NV has recently installed a just-in-time ( JIT) inventory system. Describe the effect this is likely to have on the company s carrying costs, shortage costs, and operating cycle. _ 9 Operating and Cash Cycles Is it possible for a firm s cash cycle to be longer than its operating cycle? Explain why or why not. 10 Shortage Costs What are the costs of shortages? Describe them.

19 Questions and Problems Reasons for Net Working Capital In an ideal economy, net working capital is always zero. Why might net working capital be positive in a real economy? Use the following information to answer Questions Last month, BlueSky Airlines announced that it would stretch out its bill payments to 45 days from 30 days. The reason given was that the company wanted to control costs and optimize cash flow. The increased payable period will be in effect for all of the company s 4,000 suppliers. 12 Operating and Cash Cycles What impact did this change in payables policy have on BlueSky s operating cycle? Its cash cycle? 13 Operating and Cash Cycles What impact did the announcement have on BlueSky s suppliers? 14 Corporate Ethics Is it ethical for large firms to unilaterally lengthen their payable periods, particularly when dealing with smaller suppliers? 15 Payables Period Why don t all firms simply increase their payables periods to shorten their cash cycles? 16 Payables Period BlueSky lengthened its payables period to control costs and optimize cash flow. Exactly what is the cash benefit to BlueSky from this change? 17 Changes in the Cash Account Indicate the impact of the following corporate actions on cash, using the letter I for an increase, D for a decrease, or N when no change occurs. (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) (n) (o) A dividend is paid with funds received from a sale of debt. Property is purchased and paid for with short-term debt. Inventory is bought on credit. A short-term bank loan is repaid. Next year s taxes are prepaid. Preference shares are redeemed. Sales are made on credit. Interest on long-term debt is paid. Payments for previous sales are collected. The trade payables balance is reduced. A dividend is paid. Production supplies are purchased and paid with a short-term note. Utility bills are paid. Cash is paid for raw materials purchased for inventory. Marketable securities are sold. 18 Cash Equation Eurasian Natural Resources plc, a Kazakhstani firm listed on the London Stock Exchange, has total non-current assets of $4,938 million. Non-current liabilities are $1,038 million. Current assets, other than cash, are $2,098 million. Current liabilities are $1,161 million. Total equity is worth $7,176 million. How much cash does the company have? 19 Changes in the Operating Cycle Indicate the effect that the following will have on the operating cycle. Use the letter I to indicate an increase, D for a decrease, and N for no change.

20 _ 738 Chapter 26 Short-Term Finance and Planning (a) (b) (c) (d) (e) (f) Receivables average goes up. Credit repayment times for customers are increased. Inventory turnover goes from 3 times to 6 times. Payables turnover goes from 6 times to 11 times. Receivables turnover goes from 7 times to 9 times. Payments to suppliers are accelerated. 20 Changes in Cycles Indicate the impact of the following on the cash and operating cycles, respectively. Use the letter I to indicate an increase, D for a decrease, and N for no change. (a) (b) (c) (d) (e) (f) The terms of cash discounts offered to customers are made less favourable. The cash discounts offered by suppliers are increased: thus payments are made earlier. An increased number of customers begin to pay in cash instead of with credit. Fewer raw materials than usual are purchased. A greater percentage of raw material purchases are paid for with credit. More finished goods are produced for inventory instead of for order. 21 Calculating Cash Collections Pindado SA has projected the following ly sales amounts for the coming year: Q1 Q2 Q3 Q4 Sales C800 C760 C940 C870 (a) Trade receivables at the beginning of the year are $300. Pindado has a 45-day collection period. Calculate cash collections in each of the four s by completing the following: Q1 Q2 Q3 Q4 Beginning receivables Sales Cash collections Ending receivables (b) Rework (a) assuming a collection period of 60 days. (c) Rework (a) assuming a collection period of 30 days. 22 Calculating Cycles Consider the following financial statement information for the Bulldog Ice plc: calculate the operating and cash cycles. How do you interpret your answer? Item Beginning ( ) Ending ( ) _ Inventory 8,413 10,158 Accounts receivable 5,108 5,439 Accounts payable 6,927 7,625 Net sales 67,312 Cost of goods sold 52,827

21 Questions and Problems Calculating Payments Lewellen Products has projected the following sales for the coming year: Q1 Q2 Q3 Q4 Sales ( ) Sales in the year following this one are projected to be 15 per cent greater in each. (a) Calculate payments to suppliers, assuming that Lewellen places orders during each equal to 30 per cent of projected sales for the next. Assume that the company pays immediately. What is the payables period in this case? Q1 Q2 Q3 Q4 Payment of accounts ( ) (b) Rework (a) assuming a 90-day payables period. Q1 Q2 Q3 Q4 Payment of accounts ( ) (c) Rework (a) assuming a 60-day payables period. Q1 Q2 Q3 Q4 Payment of accounts ( ) 24 Calculating Payments Marshall plc purchases from suppliers in a are equal to 75 per cent of the next s forecast sales. The payables period is 60 days. Wages, taxes and other expenses are 20 per cent of sales, and interest and dividends are 60 per. No capital expenditures are planned. Here are the projected ly sales: Q1 Q2 Q3 Q4 Sales ( ) Sales for the first of the following year are projected at 970. Calculate the company s cash outlays by completing the following: Payment of accounts Wages, taxes, other expenses Long-term financing expenses (interest and dividends) Total Q1 Q2 Q3 Q4 25 Calculating Cash Collections The following is the sales budget for Freezing Snow plc for the first of 2010:

22 _ 740 Chapter 26 Short-Term Finance and Planning January February March Sales budget ( ) 150, , ,000 Credit sales are collected as follows: 65 per cent in the month of the sale. 20 per cent in the month after the sale. 15 per cent in the second month after the sale. The accounts receivable balance at the end of the previous was 57,000 ( 41,000 of which was uncollected December sales). (a) (b) (c) Compute the sales for November. Compute the sales for December. Compute the cash collections from sales for each month from January to March. CHALLENGE Calculating the Cash Budget Here are some important figures from the budget of Sagmo AB for the second of 2010: April (NKr) May (NKr) June (NKr) Credit sales 380, , ,000 Credit purchases 147, , ,500 Cash disbursements Wages, taxes, and expenses 39,750 48,210 50,300 Interest 11,400 11,400 11,400 Equipment purchases 83,000 91,000 0 The company predicts that 5 per cent of its credit sales will never be collected, 35 per cent of its sales will be collected in the month of the sale, and the remaining 60 per cent will be collected in the following month. Credit purchases will be paid in the month following the purchase. In March 2010 credit sales were NKr210,000, and credit purchases were NKr156,000. Using this information, complete the following cash budget: April (NKr) May (NKr) June (NKr) _ Beginning cash balance 280,000 Cash receipts Cash collections from credit sales Total cash available Cash disbursements Purchases Wages, taxes, and expenses Interest Equipment purchases Total cash disbursements Ending cash balance