part vii short term financial planning and management prepared by: thomas j. cottrell modified by:...

Part VII Short Term Financial Planning and Management

Prepared by: Thomas J. CottrellModified by: Carlos Vecino HEC-Montreal

Chapter 18Short-Term Finance and Planning

Chapter 19Cash and Liquidity Management

Chapter 20Credit and Inventory Management

FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 McGraw-Hill Ryerson, Ltd Slide 1


Managers Who Deal with Short-Term Financial Problems (Table 18.1)

Duties related to short-termTitle of manager financial management Assets/liabilities influenced

Cash manager Collection, concentration, disbursement; Cash, marketable short-term investments; short-term borrowing; securities, short-term loans

banking relations

Credit manager Monitoring and control of accounts Accounts receivablereceivable; credit policy decisions

Marketing manager Credit policy decisions Accounts receivable

Purchasing manager Decisions on purchases, suppliers; may Inventory, accounts payablenegotiate payment terms

Production manager Setting of production schedules and Inventory, accounts payablematerials requirements

Payables manager Decisions on payment policies and on Accounts payablewhether to take discounts

Controller Accounting information on cash flows; Accounts receivable, reconciliation of accounts payable; application accounts payableof payments to accounts receivable

Source: Ned C. Hill and William L. Sartoris, Short-Term Financial Management, 2nd ed. (New York: Macmillan, 1992), p. 15.


Survey: The Importance of Short-Term Finance and Planning

Long-term investment decisions (capital budgeting) and long-term financing decisions are characterized by the facts that they (a) generally involve large amounts of money, and (b) are relatively infrequent occurrences.

Decisions that come under the heading “short-term finance” are equally important, because, while typical decisions often don’t involve as much money, decisions are much more frequent. This is suggested in the results of a recent survey of CFOs.

Ranked Greatest Average Time Activity Importance Allocated

Financial Planning 59% 35%

Working Capital Mgmt. 27% 32%

Capital Budgeting 9% 19% Long-Term Financing 5% 14%

Total 100% 100%


Cash Flow Time Line (Figure 18.1) Operating and Cash cycles


Hermetic, Inc., Operating Cycle

The operating cycle

a) Finding the inventory period

COGS $480 Inventory turnover = = = 1.362 times

Avg. inventory $352.5

365Inventory period = = 268 days 1.362 times


Hermetic, Inc., Operating Cycle (concluded)

b) Finding the accounts receivable period

Credit sales $710Receivables turnover = = = 2.491 times Avg. receivables $285

365Receivables period = = 147 days 2.491 times

Operating cycle = Inventory period + Receivables period

= 268 + 147 = 415 days


Hermetic, Inc., Cash Cycle The cash cycle

a) Finding the payables turnover

COGSPayables turnover = Avg. payables

$480= = 2.043 times $235

365Payables period = = 179 days 2.043 times

Cash cycle = Operating cycle - Payables period = 415 - 179 = 236 days


The Size of the Firm’s Investment in Current Assets

The size of the firm’s investment in current assets is determined by its short-term financial policies.

Flexible policy actions include: Keeping large cash and securities balances

Keeping large amounts of inventory

Granting liberal credit terms

Restrictive policy actions include: Keeping low cash and securities balances

Keeping small amounts of inventory

Allowing few or no credit sales

Is it better Flexible or Restrictive ?


Cost of holding current assets

Carrying cost (costs that rise with the amount held in assets)

Financial cost, storage cost and other costs of holding current assets.

Shortage cost (cost that decrease with the amount held in assets)

Cost of not having current assets available on-hand, or having to get them rapidly.

The optimal choice of holding current assets is a trade-off of:

Carrying costs versus Shortage costs:


Total Cost of holding current assets (Cash, receivables and inventory)

Carrying cost

Shortage cost

Total holding cost

Amount of assets

Cost ($)


Car

ryin

g C

ost

s an

d S

ho

rtag

e C

ost

s (F

igu

re 1

8.2)


Carrying Costs and Shortage Costs (Figure 18.2) When is a “Flexible policy” appropriate?


Carrying Costs and Shortage Costs (Figure 18.2) When is a “Restrictive policy” appropriate?


Financing Policy for an “Ideal” Economy (Figure 18.3)


Alternative Asset Financing Policies (Figure 18.5)


A Compromise Financing Policy (Figure 18.6)


A Closer look to Cash, Credit and Inventory

Cash policy What is the tradeoff between carrying a large versus a small cash

balance?

What is the proper management of the cash balance?

Credit policy What is the tradeoff between a flexible versus a restrictive credit

policy? Analysis of a credit policy change Credit information and evaluation of customer credit capacity

Inventory policy What are the components of an inventory management system? Use of EOQ inventory model Inventory management systems



Cash Policy

Credit Policy

Inventory Policy


Reasons for Holding Cash

Speculative Motive - the need to hold cash to take advantage of additional investment opportunities, such as bargain purchases.

Precautionary Motive - the need to hold cash as a safety margin to act as a financial reserve.

Transaction Motive - the need to hold cash to satisfy normal disbursement and collection activities associated with a firm’s ongoing operations.

Compensating Balance Requirements - cash balances kept at commercial banks to compensate for banking services the firm receives.


Determining the Target Cash Balance

Optimal choice of cash balance is a trade-off of Carrying costs: Opportunity costs of holding cash instead

of some other income-producing asset.

versus

Shortage costs:Cost of not having cash available on-hand,or having to rapidly get the cash.

Other factors influencing the target cash balance

Ability to borrow rather than marketable securities

Scale economies in cash management - large firm advantage.


Determining the Target Cash Balance (Figure 19.1)


Cash Balances - The Baumol-Allais-Tobin BAT Model

Ca

sh

B

ala

nc

e

Time in days, weeks, etc.

Minimum cash allowed

Average (C/2)

Ending=0

2 4

Starting (C)


Cost minimization model

We seek to find the minimum cost of meeting the short-term cash needs

F = Fixed cost of selling securities to replenish cash

T = Total amount of new cash needed for transactions purposes over the relevant planning period (e.g. over a year)

R = Opportunity cost of holding cash (e.g. the interest rate on marketable securities)

Total Cost = Total Opportunity cost + Total Trading cost

Total Opportunity cost = (Average balance) (R) = (C/2)(R)

Total Trading cost = (T/C) (F)

Total Cost = (C/2)(R) + (T/C) (F)


Optimal Solution

Differentiate the Total Cost with respect to the cash balance to find the...

Optimal Cash Balance, when dTC/dC = R/2 + (-1)TF/C2 = 0

R

TFC

2*


Example 19A.1 (pp 663-664)

T = Total Cash needed per year = 365 * $100 = $36,500

Optimal Balance (C*) C = SQRT(2TF/R) = SQRT(2 * $36,500 * $10 / 0.05) = $3,821 Optimal Balance (C*) =$3,821 Average Cash Balance = $ 1,911

Total cost Opportunity Costs = C/2*R= $1,911 (0.05) = $96 The re-supply time is $3,821/$100 per day = 38.21 days Number of re-supplies per year = 365 / 38.21 = 9.6 times Total Trading Costs = 9.6 ($10) = $96 Total Cost = Opportunity cost + Trading cost = $96 + $96 Total Cost = $192

Vulcan corp. has outflows of $100 per day, seven days a weekR= 5%, F=$10 per transaction C* = ? Total Cost = ?


The Cash Budget

Objective: Identification of short term financial needs, cash surpluses or deficits.

Main source of cash : Sales and Cash Collections

Other sources of cash: Asset sales, investment income, loans, increase in equity, etc.

Main Cash Outflows : Payments of accounts payable Wages, Utilities and other expenses Taxes Capital expenditures – Fixed assets acquisitions Debt services and principal payments


Example: Cash Budget for Ajax Company

All sales on credit Dec. sales were $95,000 ; Expected Jan 55,000 Feb & March 65,000 December 31 receivables were $135,000 Accounts receivable period is 45 days (50% - 30 days, 50% - 60 days) Wages, taxes, and other expenses are 30% of sales Raw materials are ordered two months in advance of sales Raw materials are 50% of sales All purchases on trade credit An annual dividend of $100,000 is expected to be paid in March No capital expenditures are planned for the first quarter The beginning cash balance is $41,000 The minimum cash balance is $25,000


Example: Cash Budget for Ajax Company (continued)

Cash collections for Ajax(all figures rounded to the nearest dollar)

JAN FEB MAR

Beginning receivables $135,000 $102,500 $ 92,500

Sales 55,000 65,000 65,000

Cash collections 87,500 75,000 60,000

Ending receivables $102,500 $ 92,500 $ 97,500



Cash disbursements for Ajax

JAN FEB MAR

Payment of accounts(50% of next month’s sales) $ 32,500 $32,500 $30,000

Wages, taxes, and other 16,500 19,500 19,500

Capital expenditures 0 0 0

Long-term financing expenses 0 0 100,000

Total $ 49,000 $52,000 $149,500



Net cash inflow for Ajax

JAN FEB MAR

Total cash collections $ 87,500 $ 75,000 $ 60,000

Total cash disbursements 49,000 52,000 149,500

Net cash inflow $ 38,500 $23,000 -$ 89,500


Example: Cash Budget for Ajax Company (concluded)

Cash balance for Ajax

JAN FEB MAR

Beginning cash balance $ 41,000 $79,500 $102,500

Net cash inflow 38,500 23,000 -89,500

Ending cash balance $ 79,500 $102,500 $ 13,000

Minimum cash balance - 25,000 - 25,000 - 25,000

Cumulative surplus (deficit) $ 54,500 $ 77,500 -$ 12,000



Credit Policy

Credit Policy

Inventory Policy


Components of Credit Policy

Terms of sale

The conditions under which a firm sells its goods and services for cash or credit.

Credit analysis

The process of determining the probability that customers will not pay.

Collection policy

Procedures followed by a firm in collecting accounts receivable.


The Cash Flows from Granting Credit

Creditsale ismade

Customermailscheck

Firm depositscheck in

bank

Bank creditsfirm’s

account

Cash collection

Accounts receivable

Time


Determinants of the Length of the Credit Period

Several factors influence the length of the credit cycle. Among these factors are:

Perishability and collateral value Consumer demand for the product Cost, profitability and standardization Credit risk of the buyer The size of the account Competition in the product market Customer type


Credit Policy Effects

Revenue effects

Payment is received later, but price and quantity sold may increase

Cost effects

Running a credit department and collecting receivables has costs

The cost of debt

The firm must finance receivables and, therefore, incur financing costs

The probability of nonpayment

The firm always gets paid if it sells for cash, but risks losses due to customer default if it sells on credit

The cash discount

Discounts induce buyers to pay early; the size of the discount affects payment patterns and amounts


Evaluating a Proposed Credit Policy

P = price per unitv = variable cost per unitQ = current quantity sold per periodQ’ = new quantity expected to be soldR = periodic required return

The benefit of switching is the change in cash flow:

New cash flow - old cash flow

[(P - v) Q’] - [(P - v) Q]

rearranging,

(P - v) (Q’ - Q)


Evaluating a Proposed Credit Policy (concluded)

The present value of switching is:

PV = [(P - v) (Q’ - Q)]/R

The cost of switching is the amount uncollected for the period + the additional variable costs of production:

Cost = PQ + v(Q’ - Q)

And the NPV of the switch is:

NPV = -[PQ + v(Q’ - Q)] + [(P - v)(Q’ - Q)]/R


The Costs of Granting Credit (Figure 20.1)


The Five C’s of Credit

Character

The borrower’s willingness to pay

Capacity

The borrower’s ability to pay

Capital

Financial reserves/borrowing capacity

Collateral

Pledged assets

Conditions

Relevant economic conditions



Credit Policy

Credit Policy

Inventory Policy


Inventory Management

Inventory Types Raw Materials Work-in-Progress Finished Goods

Inventory Costs Storage and tracking costs Insurance and taxes Losses due to obsolescence, deterioration, or theft Opportunity cost of capital on the invested amount


Costs of Holding Inventory (Figure 20.5)


Inventory Management Techniques

ABC Approach Compare number of items with the value of the items An illustration of the “80-20” rule

EOQ ModelEconomic Order Quantity is most widely known approach. Inventory depletion rate Carrying costs Shortage costs and Restocking costs Total costs

Extensions to EOQ Safety stocks Reorder points

MRP - Material Requirements Planning

Just-in-Time Inventory


ABC Inventory Analysis (Figure 20.4)


Inventory Holdings for the Transcan Corporation (Figure 20.6 )

The Transcan Corporation starts with inventory of 3,600 units. The quantity drops to zero by the end of the fourth week. The average inventory is Q/2 = 3,600/2 = 1,800 over the period.


Cost minimization –The Economic Order Quantity EOQ model

We seek to find the minimum cost of holding inventory by defining what size order the firm should place when restocking.

Q = Quantity of restocking (size order)

F = Fixed cost per order

T = Total unit sales per year

CC = Carrying Cost of holding inventory (e.g. financial, storage, insurance, obsolescence, deterioration and theft costs)

Total Cost = Total Carrying cost + Total Restocking cost

Total Carrying cost = (Average stock) (CC) = (Q/2)(CC)

Total Restocking cost = (T/Q) (F)

Total Cost = (Q/2)(CC) + (T/Q) (F)


Optimal Solution

Differentiate the Total Cost with respect to the size order “Q” to find the...

Optimal size order “Q*”, when dTC/dQ = CC/2 + (-1)TF/Q2 = 0

CC

TFQ

2*


Solution to Problem 20.11

Bell Mfg. uses 1,600 switch assemblies per week and then reorders another 1,600. If the relevant carrying cost per assembly is $40, and the fixed order cost is $800, is Bell’s inventory policy optimal? Why or why not?

Carrying costs = (_____/2)($40) = $_____

Order costs = (52)($_____) = $_____

EOQ = [2(52)(1,600)($800)/$40]1/2 = _____ units

The firm’s policy (is/is not) optimal, since the costs are not equal.

Bell should _______ the order size and _______ the number of orders per year.


Solution to Problem 20.11

Bell Mfg. uses 1,600 switch assemblies per week and then reorders another 1,600. If the relevant carrying cost per assembly is $40, and the fixed order cost is $800, is Bell’s inventory policy optimal? Why or why not?

Carrying costs = (1,600/2)($40) = $32,000

Order costs = (52)($800) = $41,600

EOQ = [2(52)(1,600)($800)/$40]1/2 = 1,825 units

The firm’s policy is not optimal, since the costs are not equal.

Bell should increase the order size and decrease the number of orders per year.


Safety Stocks

Material Requirements Planning (MRP) - Safety Stocks and Reorder Points (Figure 20.7)

Inventory

Time

Minimum inventory level

A. Safety Stocks



Inventory

Time


B. Reorder points

Delivery time

Delivery time


Safety Stocks


Inventory

Time


B. Reorder points

Delivery time

Delivery time


Just – in – Time Inventory

Basic Idea: Parts, Raw Material and in general “Work In Process components” are delivered exactly as needed for production

Objective: Minimize Inventory

Production Objective?

Is Just-in-time consistent with EOQ?

Financial Objective ?

How does JIT fits into Du-Pont?

part vii short term financial planning and management prepared by: thomas j. cottrell modified by:...

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