13Short-Term Finance

and Planning

13.1Working Capital Management

Working CapitalCurrent, or short-term, assets and liabilities are

collectively known as working capital.Net working capital = Current assets – Current

liabilities

Working Capital ManagementShort-term financial Management

= Working capital managementManaging working capital is a daily activity that

ensures that the firm has sufficient resources to continue its operations and avoid costly interruptions.

Working capital management involves the administration, within policy guidelines, of current assets and current liabilities.

Cash and Net Working CapitalRearrange balance sheet identity

Net working capital + Fixed assets = Long-term debt + Equity

Net working capital = Cash + Other current assets – Current liabilities

Cash = Long-term debt + Equity + Current liabilities – Current assets other than cash – Fixed

assetsSources of cash

Increasing long-term debt, equity, or current liabilitiesDecreasing current assets other than cash, or fixed

assetsUses of cash

Decreasing long-term debt, equity, or current liabilities Increasing current assets other than cash, or fixed

assets

The Operating Cycle and the Cash Cycle

The Operating CycleOperating cycle – the period from inventory

purchase to the receipt of cashInventory period – the period required to

purchase and sell the inventoryAccounts receivable period – the period

required to collect on credit salesOperating cycle = Inventory period +

Accounts receivable period

The Cash CycleCash cycle – the period from when cash is

paid out to when is received. Accounts payable period – the period from

inventory purchase to payment for the inventory

Cash cycle = Operating cycle – Accounts payable period

Operating Cycle and Cash Cycle: Example

Item Beginning Ending

Inventory $2546 $2802

Accounts

receivable

7564 6736

Accounts

payable

3590 4050

Net sales$29500

Cost of goods

sold

22750

Operating Cycle and Cash Cycle: ExampleInventory

turnover=$22750/[(2546+2802)/2]=8.51 timesInventory period=365 days/8.51times=42.89

daysReceivable

turnover=$29500/[(7564+6736)/2]=4.13 timesReceivables period=365 days/4.13times = 88.38

daysPayables

turnover=$22750/[(3590+4050)/2]=5.96 timesPayables period=365 days/5.96times = 61.24

daysOperating cycle=42.89 days+88.38 days=131

daysCash cycle=131 days-61.24days=70 daysInventory has to be financed for 70 days.

Cash Flows and Working Capital ManagementThe need for short-term financial

management is suggested by the gap between cash inflows and cash outflows.

The gap between cash inflows and cash outflows can be filled either by borrowing or by holding a liquidity reserve in the form of cash or marketable securities.

The gap between cash inflows and cash outflows can be shortened by changing the inventory, receivable and payable periods.

13.2Short-Term Financial Policy

Short-Term Financial PolicyThe size of investments in current assets

Flexible policy – maintain a high ratio of current assets to sales

Restrictive policy – maintain a low ratio of current assets to sales

The financing of current assetsFlexible policy – a low proportion of short-term

debt relative to long-term financing.Restrictive policy – a high proportion of short-

term debt relative to long-term financing.

The size of investments in current assetsA flexible short-term financial policy

Keeping large balances of cash and marketable securities.

Making large investments in inventory.Granting liberal credit terms.

A restrictive short-term finance policyKeeping low cash balances and making little

investment in marketable securities.Making small investments in inventory.Allowing few or no credit sales.

Carrying Costs and Shortage CostsCarrying costs

Increase with the level of investment in current assetsCosts of maintaining economic value and opportunity

costsShortage costs

Decrease with the level of investment in current assetsTrading, or order, costs and costs related to lack of safety

reserves

Managing short-term assets involves a trade-off between carrying costs and shortage costs.

A flexible policy is most appropriate when carrying costs are low relative to shortage costs.

A restrictive policy is most appropriate when carrying costs are high relative to shortage costs.

The Optimal Investment in Current Assets

The Financing of Current AssetsA flexible short-term financing policy

A low proportion of short-term debt relative to long-term financing.

A restrictive short-term financing policyA high proportion of short-term debt relative to

long-term financing.

The Financing of Current AssetsIn an ideal economy, short-term assets can always be

financed with short-term debt and long-term assets can always be financed with long-term debt. The net working capital is always zero.

In a real economy, it is not likely that current assets will ever drop to zero. Firms generally need to carry a minimum level of “permanent” current assets at all times.

A growing firm usually has a total asset requirement of current assets and current liabilities. The total asset may change because of (1) a general growth trend, (2) seasonal variation around the trend and (3) unpredictable day-to-day and month-to-month fluctuations.

The Financing of Current AssetsA flexible policy has a short-term cash

surplus and a large investment in cash and marketable securities.

A restrictive policy uses long-term financing for permanent assets requirements only and short-term borrowing for seasonal variations.

A compromise policy means the firm keeps a reserve of liquidity that it uses to initially finance seasonal variations in current asset needs. Short-term borrowing is used when the reserve is exhausted.

The Best Financing PolicyThere is no definitive answer.Several considerations must be included in a

proper analysis.Cash reservesMaturity hedgingRelative interest Rates

13.3Cash Budgeting

Cash BudgetingCash Budgeting records estimates of cash

inflows and outflows over a specified period.The result of cash budgeting is an estimate of

the cash surplus or deficit.It is a primary tool in short-term financial

planningIt helps determine what borrowing is

required or what lending will be possible in the short run.

Cash Budgeting: ExampleApril May June

Credit sales $390,000 $364,000 $438,000

Credit purchases 147,800 176,300 208,500

Cash disbursements

Wages, taxes and expenses 53,800 51,000 78,300

Interest 13,100 13,100 13,100

Equipment purchases 87,000 147,000 0Above are some important figures for the second quarter of the year. The company predicts that 5% of its credit sales will never be collected,

35% of its sales will be collected in the month of the sale, and the remaining 60% will be collected in the following month. Credit purchases will be paid in the month following the purchase.

In march, credit sales were $245,000 and credit purchases were $168,000.

Cash Budgeting: ExampleApril May June

Beginning cash balance $140,000 $101,600 $104,100Cash receipts

Cash collections from credit sales 283,500 361,400 371,700 Total cash available $423,500 $463,000 $475,800Cash disbursements

Purchases $168,000 $147,800 $176,300 Wages, taxes and expenses 53,800 51,000 78,300 Interest 13,100 13,100 13,100 Equipment purchases 87,000 147,000 0 Total cash disbursements $321,900 $358,900 $267,700Ending cash balance $101,600 $104,100 $208,100

13.4Short-Term Borrowing

Short-Term BorrowingThe most common way to finance a

temporary cash deficit to arrange a short-term loan.

LoansUnsecured loansSecured loans

Other sourcesCommercial paperTrade Credit

Compensating BalanceThe company has a $100,000 line of credit

with a 10% compensating balance requirement. The quoted interest rate is 16%. The company needs to borrow $54,000 for one year. How much do the company need to borrow?

$54,000 / (1- 0.10) = $60,000$60,000*16%=$9,600$9,600/54,000=17.78%