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Short-Term Financial Planning Handout Rev 1a.Docx Page 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)
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
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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.
Short-Term Financial Planning Handout Rev 1a.Docx Page 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 = 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:
Page 4 Short-Term Financial Planning Handout Rev 1a.Docx
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
Short-Term Financial Planning Handout Rev 1a.Docx Page 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
Page 6 Short-Term Financial Planning Handout Rev 1a.Docx
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.
Short-Term Financial Planning Handout Rev 1a.Docx Page 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 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)
Page 8 Short-Term Financial Planning Handout Rev 1a.Docx
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
Short-Term Financial Planning Handout Rev 1a.Docx Page 9
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
Page 10 Short-Term Financial Planning Handout Rev 1a.Docx
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
Ending cash balance $100,000.00 $100,000.00 $100,000.00 $100,000.00
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.
Q2: Excess funds at start of quarter of $94,622.22 earns $946.22 in income.
Q3: Excess funds at start of quarter of $98,290.67 earns $982.91 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%
Short-Term Financial Planning Handout Rev 1a.Docx Page 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 $190,000.00 $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 80,000.00 80,000.00 80,000.00 80,000.00
Cumulative surplus (deficit) $113,722.22 $116,444.44 $155,555.56 –$47,222.22
Short-term Financial Plan
Target cash balance $80,000.00 $80,000.00 $80,000.00 $80,000.00
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
Ending cash balance $80,000.00 $80,000.00 $80,000.00 $80,000.00
Minimum cash balance –80,000.00 –80,000.00 –80,000.00 –80,000.00
Cumulative surplus (deficit) $0 $0 $0 $0
Beginning short-term investments $110,000.00 $114,822.22 $118,692.67 $158,990.70
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.
Q2 Excess funds at start of quarter of $114,822.22 earns $1,148.22 in income.
Q3 Excess funds at start of quarter of $118,692.67 earns $1,186.93 in income.
Q4 Excess funds at start of quarter of $158,990.70 earns $1,589.91 in income.
Net cash cost
Q1 $1,100.00
Q2 1,148.22
Q3 1,186.93
Q4 1,589.91
Cash generated by short-term financing $5,025.06
Page 12 Short-Term Financial Planning Handout Rev 1a.Docx
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 $484,000.00 $360,552.00 $410,352.00 $462,144.00
Sales collection in current Q 540,828.00 615,528.00 693,216.00 741,024.00
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
Short-Term Financial Planning Handout Rev 1a.Docx Page 13
So, the cash balance each quarter will be:
Cash Balance Q1 Q2 Q3 Q4
Beginning cash balance $190,000.00 $362,494.67 $384,908.00 $444,142.67
Net cash inflow 172,494.67 22,413.33 59,234.67 –192,498.67
Ending cash balance $362,494.67 $384,908.00 $444,142.67 $251,644.00
Minimum cash balance 80,000.00 80,000.00 80,000.00 80,000.00
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:
Short-term Financial Plan Q1 Q2 Q3 Q4
Target cash balance $80,000.00 $80,000.00 $80,000.00 $80,000.00
Net cash inflow 172,494.67 22,413.33 59,234.67 –192,498.67
Income on short-term investments 1,100.00 2,835.95 3,088.44 3,711.67
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
Ending cash balance $80,000.00 $80,000.00 $80,000.00 $80,000.00
Minimum cash balance –80,000.00 –80,000.00 –80,000.00 –80,000.00
Cumulative surplus (deficit) $0 $0 $0 $0
Beginning short-term investments $110,000.00 $283,594.67 $308,843.95 $371,167.05
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:
Q1: Excess funds at start of quarter of $110,000.00 earns $1,100.00 in income.
Q2: Excess funds at start of quarter of $283,594.67 earns $2,835.95 in income.
Q3: Excess funds at start of quarter of $308,843.95 earns $3,088.44 in income.
Q4: Excess funds at start of quarter of $371,167.05 earns $3,711.67 in income.
Page 14 Short-Term Financial Planning Handout Rev 1a.Docx
The net cash cost is:
Net cash cost
Q1 $1,100.00
Q2 2,835.95
Q3 3,088.44
Q4 3,711.67
Cash generated by short-term financing $10,736.06
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 $484,000.00 $360,552.00 $410,352.00 $462,144.00
Sales collection in current Q 540,828.00 615,528.00 693,216.00 741,024.00
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:
Cash Balance Q1 Q2 Q3 Q4
Beginning cash balance $190,000.00 $350,182.17 $361,633.00 $418,067.67
Net cash inflow 160,182.17 11,450.83 56,434.67 -150,136.17
Ending cash balance $350,182.17 $361,633.00 $418,067.67 $267,931.50
Minimum cash balance 80,000.00 80,000.00 80,000.00 80,000.00
Cumulative surplus (deficit) $270,182.17 $281,633.00 $338,067.67 $187,931.50
Short-Term Financial Planning Handout Rev 1a.Docx Page 15
The short-term financial plan will be:
Short-term Financial Plan Q1 Q2 Q3 Q4
Target cash balance $80,000.00 $80,000.00 $80,000.00 $80,000.00
Net cash inflow 160,182.17 11,450.83 56,434.67 -150,136.17
Income on short-term investments 1,100.00 2,712.82 2,854.46 3,447.35
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
Ending cash balance $80,000.00 $80,000.00 $80,000.00 $80,000.00
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
Beginning short-term investments $110,000.00 $271,282.17 $285,445.82 $344,734.95
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:
Q1: Excess funds at start of quarter of $110,000.00 earns $1,100.00 in income.
Q2: Excess funds at start of quarter of $271,282.17 earns $2,712.82 in income.
Q3: Excess funds at start of quarter of $285,445.82 earns $2,854.46 in income.
Q4: Excess funds at start of quarter of $344,734.95 earns $3,447.35 in income.
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
Cash generated by short-term financing $10,114.63
The effective annual rate the company’s suppliers are offering to Sunny is:
EAR =
Page 16 Short-Term Financial Planning Handout Rev 1a.Docx
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%.
Short-Term Financial Planning Handout Rev 1a.Docx Page 17
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
Page 18 Short-Term Financial Planning Handout Rev 1a.Docx
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.