Chapter 26 Short-Term Finance and Planning

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1 University of Science and Technology Beijing Dongling School of Economics and management Chapter 26 Short-Term Finance and Planning Dec Dr. Xiao Ming USTB 1

2 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 Dr. Xiao Ming USTB 2

3 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 Dr. Xiao Ming USTB 3

4 Balance Sheet Model of the Firm Current Assets Net Working Capital Current Liabilities Long-Term Debt Fixed Assets 1. Tangible 2. Intangible How much shortterm cash flow does a company need to pay its bills? Shareholders Equity Dr. Xiao Ming USTB 4

5 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 5

6 Defining Cash in Terms of Other Elements Net Working Capital + Fixed Assets = Long- Term Debt + Equity Net Working Capital = Cash + Other Current Assets Current Liabilities Cash = Long- Term Debt + Equity Net Working Capital (excluding cash) Fixed Assets Dr. Xiao Ming USTB 6

7 Defining Cash in Terms of Other Elements Cash = Long- Term Debt + Equity Net Working Capital (excluding cash) Fixed Assets 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 7

8 26.2 The Operating Cycle and the Cash Cycle Raw material purchased Finished goods sold Cash received Order Placed Stock Arrives Inventory period Accounts payable period Accounts receivable period Time Firm receives invoice Cash paid for materials Operating cycle Cash cycle Dr. Xiao Ming USTB 8

9 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. Dr. Xiao Ming USTB 9

10 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 10

11 Example Inventory period Average inventory = (200, ,000)/2 = 250,000 Inventory turnover = 820,000 / 250,000 = 3.28 times Inventory period = 365 / 3.28 = days Receivables period Average receivables = (160, ,000)/2 = 180,000 Receivables turnover = 1,150,000 / 180,000 = 6.39 times Receivables period = 365 / 6.39 = 57.1 days Operating cycle = = days Dr. Xiao Ming USTB 11

12 Example Payables Period Average payables = (75, ,000)/2 = 87,500 Payables turnover = 820,000 / 87,500 = 9.37 times Payables period = 365 / 9.37 = 38.9 days Cash Cycle = = days We have to finance our inventory for days. If we want to reduce our financing needs, we need to look carefully at our receivables and inventory periods they both seem excessive. Dr. Xiao Ming USTB 12

13 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 13

14 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) Dr. Xiao Ming USTB 14

15 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 15

16 Appropriate Flexible Policy $ Minimum point Carrying costs Total costs of holding current assets. Shortage costs CA * Investment in Current Assets ($) Dr. Xiao Ming USTB 16

17 Appropriate Restrictive Policy $ Minimum point Total costs of holding current assets. Carrying costs CA * Shortage costs Investment in Current Assets ($) Dr. Xiao Ming USTB 17

18 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 18

19 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 Dr. Xiao Ming USTB 19

20 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 20

21 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. Q1 Q2 Q3 Q4 Beginning Receivables Sales Cash Collections Ending Receivables Dr. Xiao Ming USTB 21

22 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 Q1 Q2 Q3 Q4 Payment of accounts Wages, taxes and other expenses Capital expenditures 200 Interest and dividend payments Total cash disbursements Dr. Xiao Ming USTB 22

23 Example Q1 Q2 Q3 Q4 Total cash collections Total cash disbursements Net cash inflow Beginning Cash Balance Net cash inflow Ending cash balance Minimum cash balance Cumulative surplus (deficit) Dr. Xiao Ming USTB 23

24 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 Dr. Xiao Ming USTB 24

25 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? Dr. Xiao Ming USTB 25

26 Dr. Xiao Ming USTB 26