Short Term Finance and Planning. Sources and Uses of Cash

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1 Short Term Finance and Planning (Text reference: Chapter 27) Topics sources and uses of cash operating cycle and cash cycle short term financial policy cash budgeting short term financial planning AFM Short Term Finance and Planning Slide 1 Sources and Uses of Cash much of short term finance revolves around net working capital. Since net working capital = current assets current liabilities net working capital + fixed assets = long term debt + equity net working capital excl. cash + cash + fixed assets = long term debt + equity, we have cash = long term debt + equity net working capital excl. cash fixed assets sources of cash: increase in liability account decrease in asset account uses of cash: increase in asset account decrease in liability account AFM Short Term Finance and Planning Slide 2

2 example: Balance Sheet ( millions) Income Statement ( millions) Current assets: Sales 700 Cash 8 10 Operating costs 642 Marketable securities Inventory Depreciation 8 Accounts receivable Total current assets Interest 2 Fixed assets: Pre-tax income 48 Gross investment Tax (50%) 24 Depreciation Net income 24 Net fixed assets Dividend 2 Total assets Retained earnings 22 Current liabilities: Bank loans 10 0 Accounts payable Total current liabilities Long term debt Net worth Total liabilities and net worth AFM Short Term Finance and Planning Slide 3 what are the sources and uses of cash? Why did cash increase by 2? sources of cash uses of cash AFM Short Term Finance and Planning Slide 4

3 Operating Cycle and Cash Cycle Raw material bought Order placed Material arrives Invoice received Inventory period Accounts payable period Finished goods sold Cash paid for material Accounts receivable period Cash received Time operating cycle: time period from arrival of raw materials inventory to receipt of cash cash cycle: time period from payment of cash for materials to receipt of cash the need for short term finance is due to the gap between cash outflows and inflows AFM Short Term Finance and Planning Slide 5 some common ratios: Inventory turnover = Receivables turnover = Payables turnover = Cost of goods sold Average inventory Credit sales Average receivables Cost of goods sold Average payables e.g.: refer back to slide 3 and assume that cost of goods sold for 2001 was 250 million and that half of sales were on credit: AFM Short Term Finance and Planning Slide 6

4 Short Term Financial Policy the main features are: 1. size of firm s investment in current assets flexible (high ratio of current assets/sales) vs. restrictive (low ratio) optimal choice is a tradeoff between carrying costs (costs that rise with the level of current assets) and shortage costs (costs that fall with the level of current assets) Flexible Policy Restrictive Policy Amount of current assets Amount of current assets AFM Short Term Finance and Planning Slide 7 2. two general possibilities for the financing of current assets: No Short Term Borrowing Short Term Borrowing Time Time AFM Short Term Finance and Planning Slide 8

5 factors to consider: importance of cash reserves: without short term borrowing, the firm must maintain investments in cash and marketable securities. This provides flexibility, and reduces the chance of financial distress, but ties up money in zero NPV investments. maturity hedging firms often try to finance assets with debt of similar maturity (e.g. inventory with short term debt). Mismatched maturities (e.g. short term debt for long term assets) can be risky ( rollover risk ). term structure the yield curve usually slopes upward, so it is typically more expensive to borrow using long term debt AFM Short Term Finance and Planning Slide 9 Cash Budgeting the cash budget provides forecasts of future cash receipts and payments it allows managers to identify possibilities for short term investments and financing example: start with cash inflows. Suppose we have the following forecasts for sales/collections: Q.1 Q.2 Q.3 Q.4 Receivables at start of quarter Sales Collections: Sales in current period (80%) Sales in last period (20%) Total collections Receivables at end of quarter there could be other sources of cash such as sale of assets, investment income, etc.; here we will simply assume that such items provide a total of 12.5 million in the 3rd quarter AFM Short Term Finance and Planning Slide 10

6 now consider cash outflows; here we assume payments on accounts payable are 65, 60, 55, and 50 million in quarters 1-4 labour and administrative expenses are 30 million per quarter capital expenditures are 32.5, 1.3, 5.5, and 8 million in quarters 1-4 taxes, interest, and dividends are 4, 4, 4.5, and 5 million in quarters 1-4 then: Q.1 Q.2 Q.3 Q.4 Sources of cash Collections on accounts receivable Other Total sources Uses of cash Payments on accounts payable Labour & admin. expenses Capital expenditures Taxes, interest, & dividends Total uses Sources minus uses AFM Short Term Finance and Planning Slide 11 we can determine the short term financing requirements as follows: Q.1 Q.2 Q.3 Q.4 Cash at start of period Change in cash balance Cash at end of period Minimum operating cash balance Cumulative short term financing req d notes: minimum operating cash balance is a contingency reserve if cumulative short term financing required were negative, this would indicate a surplus in practice, one would want to do sensitivity/scenario analyses to assess the uncertainty in cash requirements before developing a short term financial plan AFM Short Term Finance and Planning Slide 12

7 Short Term Financial Planning having estimated cash requirements, the next step is planning how to borrow/invest appropriately in the previous example, the firm must raise cash in every period there are many alternative ways of short term borrowing: operating loans/lines of credit accounts receivable financing inventory loans commercial paper/banker s acceptances short term investing is usually in items such as Treasury bills, bank accounts, etc. in the previous example, other possibilities include long term financing for the capital expenditures or stretching payables AFM Short Term Finance and Planning Slide 13

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