1. Define the operating and cash cycles. Why are they important?

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1 Short-Term Planning Learning Objectives 1. Define the operating and cash cycles. Why are they important? 2. Define the different types of short-term financial policy 3. Understand the essentials of short-term financial planning. 4. Calculate the sources and uses of cash on the balance sheet. Many view short-term finance generally, and working capital management specifically, as less important than capital budgeting or the risk-return relationship. This is mistaken. Short-term planning or working capital management is important. First, discussions with CFOs quickly lead to the conclusion that, as important as capital budgeting and capital structure decisions are, they are made less frequently, while the day-to-day complexities involving the management of net working capital (especially cash and inventory) consume tremendous amounts of management time. Second, it is clear that while poor long-term investment and financing decisions will adversely impact firm value, poor short-term financial decisions will impair the firm s ability to continue operating. Finally, good working capital decisions can also have an impact on firm value. Questions for Financial Managers: What is a reasonable level of cash to keep on hand? How much should the firm borrow in the short term? How much credit should be extended to customers? Cash and Net Working Capital Balance sheet identity (rearranged) NWC + fixed assets = long-term debt + equity NWC = cash + other CA CL Cash = long-term debt + equity + CL CA other than cash fixed assets Sources (p 580 & 581) Uses Increasing long-term debt, equity, or current liabilities Decreasing current assets other than cash, or fixed assets Decreasing long-term debt, equity, or current liabilities Increasing current assets other than cash, or fixed assets Short-Term Financial Planning Handout Rev 1a.Docx Page 1

2 Does net working capital always increases when cash increases. Let s work an example: Suppose a firm currently has $50,000 in current assets and $20,000 in current liabilities; so NWC = $50,000 20,000 = 30,000. Management decides to borrow $10,000 using long-term debt. What happens to cash and NWC? Cash increases by $10,000 and NWC = (50, ,000) 20,000 = 40,000. So, both cash and NWC increase by 10,000. Suppose, on the other hand, management borrowed the $10,000 from a bank as a short-term loan. Cash still increases by $10,000, but net working capital doesn t change (NWC = (50, ,000) (20, ,000) = 30,000). The effect of an increase in cash on NWC depends on where the increase comes from; if the increase comes from a change in long-term liabilities, equity or fixed assets, then there will be an increase in NWC. On the other hand, if the increase comes from a change in current liabilities or current assets, then there will be no impact on NWC. Look at the table at the bottom of 581. Defining the Operating Cycle Operating cycle: time between purchasing the inventory and collecting the cash from sale of the inventory Inventory period: time required to purchase and sell the inventory Accounts receivable period: time required to collect on credit sales Operating cycle = inventory period + accounts receivable period Defining the Cash Cycle Amount of time we finance our inventory Difference between when we receive cash from the sale and when we have to pay for the inventory Accounts payable period time between purchase of inventory and payment for the inventory Cash cycle = Operating cycle accounts payable period Figure 18.1 on page 583 is a concise method to think about the operating and cash cycles. Normally a company would prefer to take as long as possible before paying bills. Accounts payable is often viewed as free credit; however, the cost of granting credit is built into the cost of the product. Note that the operating cycle begins when inventory is purchased and the cash cycle begins with the payment of accounts payable. Page 2 Short-Term Financial Planning Handout Rev 1a.Docx

3 Consider the following financial statement information for the Brembro Corporation: Item Beginning Ending Inventory $9,780 $11,380 Accounts receivable 4,108 4,938 Accounts payable 7,636 7,927 Net Credit sales $89,804 Cost of goods sold 56,384 The operating cycle is the inventory period plus the receivables period. The inventory turnover and inventory period are: Inventory turnover = COGS/Average inventory Inventory turnover = Inventory turnover = Inventory period = 365 days/inventory turnover Inventory period = Inventory period = And the receivables turnover and receivables period are: Receivables turnover = Credit sales/average receivables Receivables turnover = Receivables turnover = Receivables period = 365 days/receivables turnover Receivables period = Receivables period = So, the operating cycle is: Operating cycle = days days Operating cycle = days The cash cycle is the operating cycle minus the payables period. The payables turnover and payables period are: Payables turnover = COGS/Average payables Payables turnover = Payables turnover = Payables period = 365 days/payables turnover Payables period = Payables period = So, the cash cycle is: Short-Term Financial Planning Handout Rev 1a.Docx Page 3

4 Cash cycle = days days Cash cycle = days The firm is receiving cash on average days after it pays its bills. Short-Term Financial Policy Size of investments in current assets This is normally measured relative to the level of operating revenues. A short-term policy is flexible if the firm maintains a high ratio of current assets to sales. A restrictive policy would have a low ratio. In addition to the level of current assets, the method of financing this investment is important. This measured by the proportion of short-term and long-term debt used finance current assets. A restrictive policy will use more short-term instead of long-term debt to buy current assets. A flexible policy will use more long-term debt. If we take these two areas together, we see that a firm with a flexible policy would have a relatively large investment in current assets, and it would finance this investment with relatively less short-term debt. The net effect of a flexible policy is thus a relatively high level of net working capital. Put another way, with a flexible policy, the firm maintains a higher overall level of liquidity. Characteristics of a flexible short-term financial Keeping large balances of cash and marketable securities. Making large investments in inventory. Granting liberal credit terms. Characteristics of a restrictive short-term financial Keeping low cash balances and making little investment in marketable securities. Making small investments in inventory. Allowing few or no credit sales. An optimal plan will balance the costs of a restrictive against the costs of a flexible policy. What are some of the factors for determining the optimal level of current assets? See Figure 18.2 on page 590 Carrying vs. Shortage costs Carrying costs increase with increased levels of current assets, the costs to store and finance the assets Shortage costs decrease with increased levels of current assets Trading or order costs Costs related to safety reserves, i.e., lost sales and customers, and production stoppages Page 4 Short-Term Financial Planning Handout Rev 1a.Docx

5 Temporary current assets Sales or required inventory build-up may be seasonal Additional current assets are needed during the peak time The level of current assets will decrease as sales occur Permanent current assets Firms generally need to carry a minimum level of current assets at all times These assets are considered permanent because the level is constant, not because the assets aren t sold Financing Policy for Current Assets See Figure 18.3 on page 591 See Figure 18.4 on page 591 See Figure 18.5 on page 592 See Figure 18.6 on page 593 Short-Term Financial Planning Handout Rev 1a.Docx Page 5

6 Cash Budget Sunny Industries Example You have recently been hired by Sunny Industries to work in the newly established treasury department. Sunny Industries is a small company that produces archival products for a variety of purchasers, primarily museums. Gary Hollinger, the owner of the company, works primarily in the sales and production areas of the company. Currently, the company puts all receivables in one document box and all payables in another. Because of the disorganized system, the finance area needs work, and that's what you've been brought in to do. The company currently has a cash balance of $190,000, and it plans to purchase new box-folding machinery in the fourth quarter at a cost of $370,000. The machinery will be purchased with cash because of a discount offered. The company's policy is to maintain a minimum cash balance of $100,000. All sales and purchases are made on credit. Gary Hollinger has projected the following gross sales for each of the next four quarters: Q1 Q2 Q3 Q4 Gross Sales $905,000 $1,030,000 $1,160,000 $1,240,000 Also, gross sales for the first quarter of next year are projected at $1,010,000. Sunny Industries currently has an accounts receivable period of 53 days and an accounts receivable balance of $605,000. Twenty percent of the accounts receivable balance is from a company that has just entered bankruptcy, and it is likely this portion of the accounts receivable will never be collected. Sunny Industries typically orders supplies equal to 50 percent of next quarter's projected gross sales in the current quarter, and suppliers are typically paid in 42 days. Wages, taxes, and other costs run about 30 percent of gross sales. The company has a quarterly interest payment of $95,000 on its long-term debt. The company uses a local bank for its short-term financial needs. It pays 1.5 percent per quarter in all short-term borrowing and maintains a money market account that pays 1 percent per quarter on all short-term deposits. Gary has asked you to prepare a cash budget and short-term financial plan for the company under the current policies. He has also asked you to prepare additional plans based on changes in several inputs. Page 6 Short-Term Financial Planning Handout Rev 1a.Docx

7 QUESTIONS 1. Use the numbers given to complete the cash budget and short-term financial plan. The cash flow each quarter will consist of the sales collection, minus the suppliers paid, expenses, dividends, interest, and capital outlays. The individual cash flows are calculated as follows: Accounts receivable collected from the previous quarter: For the 1 st quarter, this is simply 80 percent of the beginning A/R balance. For the remaining quarters, the company will collect (53/90) percent of the previous quarter sales since this is the balance remaining at the end of the quarter. Accounts receivable from current quarter sales: The company will collect ((90 53)/90) percent of the current quarter sales. Purchases last quarter paid this quarter: The company purchases one-half of next quarter sales in the current quarter and takes 42 days to pay the accounts payable. So, the accounts payable balance at the beginning of each quarter will be: Payments for purchases from last quarter = (42/90)(Current quarter sales)(.50) Purchases for next quarter paid this quarter: Using the same payables period, the company will pay part of the current quarter orders. The current quarter orders are based on next orders sales, so: Purchase paid for next quarter = ((90 42)/90)(Next quarter sales)(.50) Short-Term Financial Planning Handout Rev 1a.Docx Page 7

8 Beginning cash balance $ 190,000 Outlay in fourth Q $ 370,000 Target cash balance $ 100,000 Q1 Q2 Q3 Q4 Gross sales $ 905,000 $ 1,030,000 $ 1,160,000 $ 1,240,000 Sales (1st quarter of next year) $ 1,010,000 Collection period (Days) 53 A/R $ 605,000 Percent uncollectible 20% % of purchases for next Q sales 50% Suppliers paid (Days) 42 % of sales for expenses 30% Interest $ 95,000 Borrowing rate 1.5% Invested securities 1.0% Beginning short-term borrowing $ - Change the following three lines for credit terms Credit terms Sunny offers 0% / 10 net 40 Percentage of customers taking credit 0% Credit terms offered to Sunny 0.0% / 15 net 40 Cash Collection Q1 Q2 A/R at beginning of Q collected (1 0.2 )(605,000) = $484, $532, Sales collection in current Q 372, , Purchases last Q paid this Q -211, , Purchase for next Q paid this Q -274, , Expenses -271, , Interest and dividends -95, , Outlay (Q4) Net cash inflow $3, $2, Page 8 Short-Term Financial Planning Handout Rev 1a.Docx

9 Cash Balance Beginning cash balance Net cash inflow Ending cash balance Minimum cash balance Cumulative surplus (deficit) Q1 Q2 Target cash balance Net cash inflow Income on short-term investments New short-term investments Short-term investments sold New short-term borrowing Interest on short-term borrowing Short-term borrowing repaid Ending cash balance Minimum cash balance Cumulative surplus (deficit) Beginning short-term investments Ending short-term investments Beginning short-term debt Ending short-term debt Short-Term Financial Planning Handout Rev 1a.Docx Page 9

10 Expenses are simply 30 percent of gross sales, while interest is constant. The cash flows for each quarter will be: Q1 Q2 Q3 Q4 A/R at beginning of Q collected $484, $532, $606, $683, Sales collection in current Q 372, , , , Purchases last Q paid this Q -211, , , , Purchase for next Q paid this Q -274, , , , Expenses -271, , , , Interest and dividends -95, , , , Outlay -370, Net cash inflow $3, $2, $39, $202, Cash Balance Q1 Q2 Q3 Q4 Beginning cash balance $190, $193, $196, $235, Net cash inflow 3, , , , Ending cash balance $193, $196, $235, $32, Minimum cash balance 100, , , , Cumulative surplus (deficit) $93, $96, $135, $67, Short-term Financial Plan Q1 Q2 Q3 Q4 Target cash balance $100, $100, $100, $100, Net cash inflow 3, , , , Income on short-term investments , New short-term investments -4, , , Short-term investments sold , New short-term borrowing , Interest on short-term borrowing Short-term borrowing repaid Ending cash balance $100, $100, $100, $100, Minimum cash balance -100, , , , Cumulative surplus (deficit) $0.00 $0.00 $0.00 $0.00 Beginning short-term investments $90, $94, $98, $138, Ending short-term investments 94, , , Beginning short-term debt Ending short-term debt $0.00 $0.00 $0.00 $63, Q1: Excess funds at start of quarter of $90, earns $ in income. Q2: Excess funds at start of quarter of $94, earns $ in income. Q3: Excess funds at start of quarter of $98, earns $ in income. Q4: Excess funds at start of quarter of $138, earns $1, in income. Net cash cost Q1 $ Q Q Q4 1, Cash generated by short-term financing $4, Rate on credit offered by Sunny Industries 0.00% Rate on credit offered to Sunny Industries 0.00% Page 10 Short-Term Financial Planning Handout Rev 1a.Docx

11 2. Rework the cash budget and short-term financial plan assuming Sunny Industries changes to a minimum balance of $80,000. If Sunny reduces its target cash balance to $80,000, the cash flows each quarter will remain the same, so they will not be repeated here. The cash balance and short-term financial plan will be: Cash Balance Q1 Q2 Q3 Q4 Beginning cash balance $190, $193, $196, $235, Net cash inflow 3, , , , Ending cash balance $193, $196, $235, $32, Minimum cash balance 80, , , , Cumulative surplus (deficit) $113, $116, $155, $47, Short-term Financial Plan Target cash balance $80, $80, $80, $80, Net cash inflow 3, , , , Income on short-term investments 1, , , , New short-term investments 4, , , Short-term investments sold , New short-term borrowing , Interest on short-term borrowing Short-term borrowing repaid Ending cash balance $80, $80, $80, $80, Minimum cash balance 80, , , , Cumulative surplus (deficit) $0 $0 $0 $0 Beginning short-term investments $110, $114, $118, $158, Ending short-term investments 114, , , Beginning short-term debt Ending short-term debt $0 $0 $0 $42, Q1 Excess funds at start of quarter of $110, earns $1, in income. Q2 Excess funds at start of quarter of $114, earns $1, in income. Q3 Excess funds at start of quarter of $118, earns $1, in income. Q4 Excess funds at start of quarter of $158, earns $1, in income. Net cash cost Q1 $1, Q2 1, Q3 1, Q4 1, Cash generated by short-term financing $5, Short-Term Financial Planning Handout Rev 1a.Docx Page 11

12 3. You have looked at the credit policy offered by your competitors and have determined that the industry standard credit policy is 1/10, net 40. The discount will begin to be offered on the first day of the first quarter. You want to examine how this credit policy would affect the cash budget and short-term financial plan. If this credit policy is implemented, you believe that 40 percent of all sales will take advantage of it, and the accounts receivable period will decline to 36 days. Rework the cash budget and short-term financial plan under the new credit policy and a minimum cash balance of $80,000. What interest rate are you effectively offering customers? If Sunny offers the discounted terms, we must assume the sales will remain unchanged. However, the effect of the discount will be to reduce the dollars received from the sales by the discount percentage for the customers who take advantage of the discount. This will change the cash flows Sunny receives. The net sales after the discount each quarter will be: Q1 net sales = Q1 net sales = $901,380 Q2 net sales = Q2 net sales = $1,025,880 Q3 net sales = Q3 net sales = $1,155,360 Q4 net sales = Q4 net sales = $1,235,040 In addition to the reduction in sales, the collections period will decrease to 36 days. The collections will be based off the lower sales figures, so the net cash inflows each quarter will be: Net cash inflow Q1 Q2 Q3 Q4 A/R at beginning of Q collected $484, $360, $410, $462, Sales collection in current Q 540, , , , Purchases last Q paid this Q 211, , , , Purchase for next Q paid this Q 274, , , , Expenses 271, , , , Interest and dividends 95, , , , Outlay 370, Net cash inflow $172, $22, $59, $192, Page 12 Short-Term Financial Planning Handout Rev 1a.Docx

13 So, the cash balance each quarter will be: Cash Balance Q1 Q2 Q3 Q4 Beginning cash balance $190, $362, $384, $444, Net cash inflow 172, , , , Ending cash balance $362, $384, $444, $251, Minimum cash balance 80, , , , Cumulative surplus (deficit) $282, $304, $364, $171, The short-term financial plan under these assumptions will be: Short-term Financial Plan Q1 Q2 Q3 Q4 Target cash balance $80, $80, $80, $80, Net cash inflow 172, , , , Income on short-term investments 1, , , , New short-term investments 173, , , Short-term investments sold , New short-term borrowing Interest on short-term borrowing Short-term borrowing repaid Ending cash balance $80, $80, $80, $80, Minimum cash balance 80, , , , Cumulative surplus (deficit) $0 $0 $0 $0 Beginning short-term investments $110, $283, $308, $371, Ending short-term investments 283, , , , Beginning short-term debt Ending short-term debt $0 $0 $0 $0 The interest earned each quarter is: Q1: Excess funds at start of quarter of $110, earns $1, in income. Q2: Excess funds at start of quarter of $283, earns $2, in income. Q3: Excess funds at start of quarter of $308, earns $3, in income. Q4: Excess funds at start of quarter of $371, earns $3, in income. Short-Term Financial Planning Handout Rev 1a.Docx Page 13

14 The net cash cost is: Net cash cost Q1 $1, Q2 2, Q3 3, Q4 3, Cash generated by short-term financing $10, The effective annual rate Sunny is offering to its customers is: EAR = 4. You have talked to the company's suppliers about the credit terms Sunny receives. Currently, the company receives terms of net 45. The suppliers have stated that they would offer new credit terms of 1.5/15, net 40. The discount would begin to be offered in the first day of the first quarter. What interest rate are the suppliers offering the company? Rework the cash budget and short-term financial plan assuming you take the credit terms on all orders and the minimum cash balance is $80,000. In addition to the discount offered to customers, Sunny is now offered a discount from suppliers. However, since the purchases from suppliers are a percentage of sales, we must assume these purchases are for raw materials, which will not change except for the discount taken. Thus, we will base the purchases off the gross sales figure. The net cash inflows each quarter will be: Net cash inflow Q1 Q2 Q3 Q4 A/R at beginning of Q collected $484, $360, $410, $462, Sales collection in current Q 540, , , , Purchases last Q paid this Q -75, , , , Purchase for next Q paid this Q -422, , , , Expenses -271, , , , Interest and dividends -95, , , , Outlay -370, Net cash inflow $160, $11, $56, $150, So, the cash balance each quarter will be: Cash Balance Q1 Q2 Q3 Q4 Beginning cash balance $190, $350, $361, $418, Net cash inflow 160, , , , Ending cash balance $350, $361, $418, $267, Minimum cash balance 80, , , , Cumulative surplus (deficit) $270, $281, $338, $187, Page 14 Short-Term Financial Planning Handout Rev 1a.Docx

15 The short-term financial plan will be: Short-term Financial Plan Q1 Q2 Q3 Q4 Target cash balance $80, $80, $80, $80, Net cash inflow 160, , , , Income on short-term investments 1, , , , New short-term investments -161, , , Short-term investments sold , New short-term borrowing Interest on short-term borrowing Short-term borrowing repaid Ending cash balance $80, $80, $80, $80, Minimum cash balance -80, , , , Cumulative surplus (deficit) $0.00 $0.00 $0.00 $0.00 Beginning short-term investments $110, $271, $285, $344, Ending short-term investments 271, , , , Beginning short-term debt Ending short-term debt $0.00 $0.00 $0.00 $0.00 The interest earned each quarter will be: Q1: Excess funds at start of quarter of $110, earns $1, in income. Q2: Excess funds at start of quarter of $271, earns $2, in income. Q3: Excess funds at start of quarter of $285, earns $2, in income. Q4: Excess funds at start of quarter of $344, earns $3, in income. And the net cash cost will be: Net cash cost Q1 $1, Q2 2, Q3 2, Q4 3, Cash generated by short-term financing $10, The effective annual rate the company s suppliers are offering to Sunny is: EAR = Short-Term Financial Planning Handout Rev 1a.Docx Page 15

16 Short-Term Borrowing Unsecured Loans Line of credit formal or informal prearranged short-term loans A line of credit is similar to a credit card. The owner of a credit card can use the line of credit on the credit card to purchase goods or services. The line of credit remains active until we abuse the privilege (i.e., late payments). There is often a cost for this line of credit in the form of annual fees. This is in addition to the often high rates of interest. College students are often targeted by credit card companies and end up holding several cards at one time. The cost of the annual fees can add up especially if they don t need the additional credit to begin with. Students also have the habit of charging to their limits and then just making the minimum payment. Commitment fee charge to secure a committed line of credit Compensating balance deposit in a low (or no) interest account as part of a loan agreement Cost of a compensating balance if the compensating balance requirement is on the used portion, less money than what is borrowed is actually available for use. If it is on the unused portion, the requirement becomes a commitment fee. Compensating Balance Example: Consider a $50,000 line of credit with a 5% compensating balance requirement. The quoted rate on the line is prime + 5%, and the prime rate is currently 8%. Suppose the firm wants to borrow $28,500. How much do they have to borrow? What is the effective annual rate? Loan Amount: 28,500 = (1 -.05)L L = 28,500 /.95 = 30,000 Effective rate: Interest paid = 30,000(.13) = 3,900. Effective rate = 3,900/28,500 =.1368 = 13.68% Trade Credit Example: Trade credit represents another source of unsecured financing. However, the cost of this form of borrowing is largely implicit, since it is represented by the opportunity cost of not taking the discount offered, if any. To compute the effective annual cost of trade credit, we first use the credit terms to determine a periodic opportunity cost. For example, if the terms are 2/10 net 30, rational managers will either pay $.98 per dollar of goods ordered on the 10 th day, or the full invoice cost on the 30 th day. In the latter case, the firm is actually paying $.02 to borrow $0.98 for 20 days. In one year, there are 365 / 20 = such periods. Therefore, the annualized cost is (1 +.02/.98) = 44.58%. Page 16 Short-Term Financial Planning Handout Rev 1a.Docx

17 Secured Loans Accounts Receivable Financing Factoring Assigning receivables receivables are security for a loan, but the borrower retains the risk of uncollected receivables Factoring receivables are sold at a discount Inventory Loans Blanket inventory lien all inventory acts as security for the loan Trust receipt borrower holds specific inventory in trust for the lender (e.g., automobile dealer financing) Field warehouse financing public warehouse acts as a control agent to supervise inventory for the lender Inventory needs to be non-perishable and marketable and not subject to obsolescence in order to be useful for inventory loans. Some view inventory financing as a means of raising additional short-term funds after receivables financing has been exhausted; however, it is standard practice in some industries, such as auto sales. An interesting discussion of inventory financing is the story of Tino De Angelis, who has come to be known as the salad oil king. Mr. De Angelis, a former butcher, constructed an empire with a reported value of $100 million (in 1963) based largely on his supposed acumen in buying and selling vegetable oil. The magnitude of his operation is apparent when you consider that at one point, he had contracted to purchase 600 million pounds of the product, or one-third of the total amount produced domestically. Unfortunately, Mr. De Angelis business acumen was greatly exaggerated. He resorted to borrowing against his inventory, which supposedly consisted of millions of gallons of vegetable oil held in steel vats spread across New Jersey. Unfortunately for his creditors, the vats were largely empty. The resulting default caused millions of dollars in losses to banks, insurance companies, brokerage firms and the New York Stock Exchange. Mr. De Angelis was paroled in 1972 after serving seven years of a 20-year prison sentence. Other Sources Commercial paper short-term publicly traded loans Trade credit accounts payable Short-Term Financial Planning Handout Rev 1a.Docx Page 17

18 A Short-Term Financial Plan The cash budget is used to determine how a firm will raise the cash to meet any cash deficits computed in the budget. It is also used to determine when marketable security investment may be necessary. For temporary imbalances, short-term borrowing and marketable securities are in order. For long-term short-falls or surpluses, long-term solutions include issuing bonds or equity to meet cash deficits and paying dividends, repurchasing shares or refunding debt for cash surpluses. Page 18 Short-Term Financial Planning Handout Rev 1a.Docx