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Short-Term Financial Planning Handout Rev 1a.Docx

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)

Increasing long-term debt, equity, or current liabilities

Decreasing current assets other than cash, or fixed assets

Uses

Decreasing long-term debt, equity, or current liabilities

Increasing current assets other than cash, or fixed assets


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 + 10,000) –

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 + 10,000) – (20,000 + 10,000)

= 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.


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 = 68.49 days + 18.38 days

Operating cycle = 86.87 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:


Cash cycle = 86.87 days – 50.37 days

Cash cycle = 36.50 days

The firm is receiving cash on average 36.50 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


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






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.


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 1st 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)


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) = $484,000.00 $532,944.44

Sales collection in

current Q 372,055.56 423,444.44

Purchases last Q

paid this Q -211,166.67 -240,333.33

Purchase for next

Q paid this Q -274,666.67 -309,333.33

Expenses -271,500.00 -309,000.00

Interest and

dividends -95,000.00 -95,000.00

Outlay (Q4)

Net cash inflow $3,722.22 $2,722.22


Cash Balance

Q1 Q2

Beginning cash balance

Net cash inflow

Ending cash balance

Minimum cash balance

Cumulative surplus (deficit)

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


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 $484,000.00 $532,944.44 $606,555.56 $683,111.11

Sales collection in current Q 372,055.56 423,444.44 476,888.89 509,777.78

Purchases last Q paid this Q -211,166.67 -240,333.33 -270,666.67 -289,333.33

Purchase for next Q paid this Q -274,666.67 -309,333.33 -330,666.67 -269,333.33

Expenses -271,500.00 -309,000.00 -348,000.00 -372,000.00

Interest and dividends -95,000.00 -95,000.00 -95,000.00 -95,000.00

Outlay -370,000.00

Net cash inflow $3,722.22 $2,722.22 $39,111.11 -$202,777.78

Cash Balance Q1 Q2 Q3 Q4

Beginning cash balance $190,000.00 $193,722.22 $196,444.44 $235,555.56

Net cash inflow 3,722.22 2,722.22 39,111.11 -202,777.78

Ending cash balance $193,722.22 $196,444.44 $235,555.56 $32,777.78

Minimum cash balance 100,000.00 100,000.00 100,000.00 100,000.00

Cumulative surplus (deficit) $93,722.22 $96,444.44 $135,555.56 -$67,222.22

Short-term Financial Plan Q1 Q2 Q3 Q4

Target cash balance $100,000.00 $100,000.00 $100,000.00 $100,000.00

Net cash inflow 3,722.22 2,722.22 39,111.11 -202,777.78

Income on short-term investments 900.00 946.22 982.91 1,383.85

New short-term investments -4,622.22 -3,668.44 -40,094.02 0.00

Short-term investments sold 0.00 0.00 0.00 138,384.68

New short-term borrowing 0.00 0.00 0.00 63,009.25

Interest on short-term borrowing 0.00 0.00 0.00 0.00

Short-term borrowing repaid 0.00 0.00 0.00 0.00


Minimum cash balance -100,000.00 -100,000.00 -100,000.00 -100,000.00

Cumulative surplus (deficit) $0.00 $0.00 $0.00 $0.00

Beginning short-term investments $90,000.00 $94,622.22 $98,290.67 $138,384.68

Ending short-term investments 94,622.22 98,290.67 138,384.68 0.00

Beginning short-term debt 0.00 0.00 0.00 0.00

Ending short-term debt $0.00 $0.00 $0.00 $63,009.25

Q1: Excess funds at start of quarter of $90,000.00 earns $900.00 in income.



Q4: Excess funds at start of quarter of $138,384.68 earns $1,383.85 in income.

Net cash cost

Q1 $900.00

Q2 946.22

Q3 982.91

Q4 1,383.85

Cash generated by short-term financing $4,212.98

Rate on credit offered by Sunny Industries 0.00%

Rate on credit offered to Sunny Industries 0.00%


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:



Net cash inflow 3,722.22 2,722.22 39,111.11 –202,777.78



Cumulative surplus (deficit) $113,722.22 $116,444.44 $155,555.56 –$47,222.22

Short-term Financial Plan


Net cash inflow 3,722.22 2,722.22 39,111.11 –202,777.78

Income on short-term investments 1,100.00 1,148.22 1,186.93 1,589.91

New short-term investments –4,822.22 –3,870.44 –40,298.04 0

Short-term investments sold 0 0 0 158,990.70

New short-term borrowing 0 0 0 42,197.17

Interest on short-term borrowing 0 0 0 0

Short-term borrowing repaid 0 0 0 0


Minimum cash balance –80,000.00 –80,000.00 –80,000.00 –80,000.00

Cumulative surplus (deficit) $0 $0 $0 $0


Ending short-term investments 114,822.22 118,692.67 158,990.70 0

Beginning short-term debt 0 0 0 0

Ending short-term debt $0 $0 $0 $42,197.17

Q1 Excess funds at start of quarter of $110,000.00 earns $1,100.00 in income.




Net cash cost

Q1 $1,100.00

Q2 1,148.22

Q3 1,186.93

Q4 1,589.91



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



Purchases last Q paid this Q –211,166.67 –240,333.33 –270,666.67 –289,333.33

Purchase for next Q paid this Q –274,666.67 –309,333.33 –330,666.67 –269,333.33

Expenses –271,500.00 –309,000.00 –348,000.00 –372,000.00

Interest and dividends –95,000.00 –95,000.00 –95,000.00 –95,000.00

Outlay –370,000.00

Net cash inflow $172,494.67 $22,413.33 $59,234.67 –$192,498.67


So, the cash balance each quarter will be:



Net cash inflow 172,494.67 22,413.33 59,234.67 –192,498.67



Cumulative surplus (deficit) $282,494.67 $304,908.00 $364,142.67 $171,644.00

The short-term financial plan under these assumptions will be:



Net cash inflow 172,494.67 22,413.33 59,234.67 –192,498.67


New short-term investments –173,594.67 –25,249.28 –62,323.11 0

Short-term investments sold 0 0 0 188,787.00

New short-term borrowing 0 0 0 0

Interest on short-term borrowing 0 0 0 0

Short-term borrowing repaid 0 0 0 0


Minimum cash balance –80,000.00 –80,000.00 –80,000.00 –80,000.00

Cumulative surplus (deficit) $0 $0 $0 $0


Ending short-term investments 283,594.67 308,843.95 371,167.05 182,380.06

Beginning short-term debt 0 0 0 0

Ending short-term debt $0 $0 $0 $0

The interest earned each quarter is:






The net cash cost is:

Net cash cost

Q1 $1,100.00

Q2 2,835.95

Q3 3,088.44

Q4 3,711.67


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



Purchases last Q paid this Q -75,416.67 -84,545.83 -95,216.67 -101,783.33

Purchase for next Q paid this Q -422,729.17 -476,083.33 -508,916.67 -414,520.83

Expenses -271,500.00 -309,000.00 -348,000.00 -372,000.00

Interest and dividends -95,000.00 -95,000.00 -95,000.00 -95,000.00

Outlay -370,000.00

Net cash inflow $160,182.17 $11,450.83 $56,434.67 -$150,136.17

So, the cash balance each quarter will be:



Net cash inflow 160,182.17 11,450.83 56,434.67 -150,136.17



Cumulative surplus (deficit) $270,182.17 $281,633.00 $338,067.67 $187,931.50


The short-term financial plan will be:



Net cash inflow 160,182.17 11,450.83 56,434.67 -150,136.17


New short-term investments -161,282.17 -14,163.65 -59,289.12 0.00

Short-term investments sold 0.00 0.00 0.00 146,688.82

New short-term borrowing 0.00 0.00 0.00 0.00

Interest on short-term borrowing 0.00 0.00 0.00 0.00

Short-term borrowing repaid 0.00 0.00 0.00 0.00


Minimum cash balance -80,000.00 -80,000.00 -80,000.00 -80,000.00

Cumulative surplus (deficit) $0.00 $0.00 $0.00 $0.00


Ending short-term investments 271,282.17 285,445.82 344,734.95 198,046.13

Beginning short-term debt 0.00 0.00 0.00 0.00

Ending short-term debt $0.00 $0.00 $0.00 $0.00

The interest earned each quarter will be:





And the net cash cost will be:

Net cash cost

Q1 $1,100.00

Q2 2,712.82

Q3 2,854.46

Q4 3,447.35


The effective annual rate the company’s suppliers are offering to Sunny is:

EAR =


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 10th

day, or the full invoice cost on the 30th

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 = 18.25

such periods. Therefore, the annualized cost is (1 + .02/.98)18.25

– 1 = 44.58%.


Secured Loans

Accounts Receivable Financing

Assigning receivables – receivables are security for a loan, but the borrower retains the

risk of uncollected receivables

Factoring – receivables are sold at a discount

Factoring

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


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.

short-term planning learning...

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